Policy

Highlights French labor reforms stack up well against German and Spanish predecessors; We remain bullish on French industrials versus German industrials; Populism is overrated in Germany - European integration may not accelerate, but it will continue; The U.K.'s position remains weak in Brexit talks ... don't expect much from sterling. Feature On recent travels across Asia Pacific, the U.K., and the U.S., Europe has rarely featured in our conversations with clients. We proclaimed European politics a "trophy red herring" in our annual Strategic Outlook.1 Following the defeat of populists in Austria, the Netherlands, Spain, and particularly France, the market now agrees with us (Chart 1). Chart 1European Political Risk Was Overstated European Political Risk Was Overstated European Political Risk Was Overstated In this report, we ask whether there is anything left to say about Europe. First, we provide an update on French structural reforms, which we predicted with enthusiasm in February.2 Second, we give a post-mortem of the German election. Third, we dissect U.K. Prime Minister Theresa May's speech in Florence. We remain positive on near-term and mid-term prospects for European assets. We have recently closed our unhedged long Euro Area equities trade for a 7.88% gain (open from January 25 to September 6). We have reopened the position on September 6 with a currency hedge given our view that there is some downside risk for the euro in the near term. We also remain long French industrials / short German industrials, with gains of 9.30% since February 3. The French Revolution Continues President Emmanuel Macron has ignored tepid union protests and signed five decrees overhauling French labor rules on September 22. While there is more to be done, Macron's swift action just five months after assuming office justifies our optimism about France earlier this year. As we posited in February, investors are surprised every decade by a developed market that defies all stereotypes and catches the markets off guard with ambitious, pro-market and pro-business structural reforms. Margaret Thatcher's laissez-faire reforms pulled Britain out of the ghastly 1970s. Sweden surprised the world in the 1990s. At the turn of the century, Germany's Social Democratic Party (SPD) defied its own "socialist" label and moved the country to the right of the economic spectrum. Finally, the past decade's reform surprise came from Spain, which undertook painful labor and pension reforms that have underpinned its impressive recovery. How do French labor reforms stack up against the German and Spanish efforts? Table 1 surveys the measures and classifies them into three categories. On unemployment benefits, Macron's effort falls short of the considerable cuts implemented as part of the Hartz reforms in Germany. However, while benefits will still be generous, France's unemployed will now be cut off if they refuse job offers that pay within 25% of the salary they previously held. On increasing labor market flexibility, we give France high marks. Reforms will simplify the termination process for economic reasons and cap damages that can be awarded to employees, in line with the Spanish experience. Macron has also managed to neuter the power of national unions by allowing firm-level collective bargaining to take precedence. France's labor bargaining reform is also a carbon copy of the Spanish effort and both are attempts to create a more German-like management-employee context. Table 1Measuring French Reforms Against German And Spanish Reforms Is There Anything Left To Say About Europe? Is There Anything Left To Say About Europe? What should investors expect as a result? Spain is instructive. While its unemployment rate remains 5.8% above the Italian rate and 7.3% above the French rate, it still fell from a high of 26.3% in 2013 to 17.1% today. Meanwhile, Italian and French unemployment rates remain stubbornly high (Chart 2). In addition, Spain's export competitiveness has had one of the sharpest recoveries in Europe since 2008, whereas Italy and France continue to languish (Chart 3). Spain accomplished this feat via a considerable reduction in labor costs relative to peers (Chart 4). Chart 2Italy, France: Unemployment Still High Italy, France: Unemployment Still High Italy, France: Unemployment Still High Chart 3Spain Regained Competitiveness Spain Regained Competitiveness Spain Regained Competitiveness Chart 4Spain Cut Labor Costs Spain Cut Labor Costs Spain Cut Labor Costs The key pillar of Prime Minister Mariano Rajoy's reforms was to create a more flexible labor market so as to restore competitiveness to the economy by aligning labor costs with productivity. Reforms, passed in February 2012, removed stringent collective bargaining agreements and replaced them with firm-level agreements. This has made it easier for firms to negotiate their own labor conditions, including reducing wages as an alternative to termination of employment. France is now on the path to do the same. True, it is difficult to establish a clear causal connection between Rajoy's structural reforms and Spain's economic performance since 2008. Nevertheless, reforms also work as a signaling mechanism, encouraging investment and unleashing animal spirits by affirming the government's commitment to a pro-business agenda. Under Rajoy's leadership, Spain has moved from 62nd in the World Bank "Ease of Doing Business" survey in 2009 to 32nd in 2017, 18 spots above Italy. Given the speed and commitment of the Macron administration, we would expect an even stronger signaling effect in France. German Hartz reforms are easier to assess because more time has passed since 2005 (when the final stage, Hartz IV, was implemented). Prior to the reforms, Germany's GDP growth rate was falling and unemployment was rising (Chart 5). At least on these two broad measures, it appears that reforms were positive. Chart 5Hartz Reforms Marked Turning Point In Germany Hartz Reforms Marked Turning Point In Germany Hartz Reforms Marked Turning Point In Germany Chart 6German Long-Term Unemployment Benefits Were Cut Down To OECD Average Is There Anything Left To Say About Europe? Is There Anything Left To Say About Europe? Germany's problem prior to the Hartz reforms was that generous unemployment benefits discouraged unemployed workers from finding employment. Long-term benefits could be as high as 53% of the terminated salary and eligible for indefinite renewal! The Hartz IV reforms specifically targeted these benefits, with the intention of forcing the unemployed to get back to work. Germany brought these benefits into line with the OECD average (Chart 6). The long-term impact of the Hartz reforms was a dramatic decline in the unemployment rate from a bottom of 9.2% in 2001 to the still falling 3.7% of today! Reforms have also seen a steady increase in wage growth, despite the conventional view saying the opposite. Wages have been steadily rising since implementation in 2005, only slowing down during the global financial crisis and the subsequent European debt crisis (Chart 7). This does not mean that labor reforms failed. The intention of the Hartz reforms was to push people back into the labor force, not necessarily suppress their wages. Chart 8 shows the effect on the hours worked in the economy, with a clear uptrend after the reform was enacted. Chart 7German Wages Recovered... German Wages Recovered... German Wages Recovered... Chart 8...While Working Hours Increased ...While Working Hours Increased ...While Working Hours Increased In line with the previous labor reform efforts in Europe, we think that investors should expect three broad developments from French labor reforms: Competitiveness: As Chart 3 suggests, Spain and Germany have had the best export performance in Europe. By allowing companies some flexibility in setting costs, these economies were able to regain export competitiveness. As a play on this theme, we are long French industrials relative to German peers. Unemployment: Forcing the unemployed back to the labor market by ending their unemployment benefits if they refuse a job offer within 25% of the previous income level should encourage workers to get back to the labor force. Confidence: Macron's labor reforms are only the beginning of a packed agenda that also includes reducing the size of the public sector, reducing the wealth tax on productive assets, and cutting corporate taxes significantly. What of the opposition to the reform effort? What if the French leadership backs down in the face of protest? First, we must ask, what protest? The labor union response has been underwhelming. In part, this is because Macron's reforms are packed with pro-union clauses. The intention is to empower union activity at the firm level in order to neuter its activity at the national level. Second, Macron's electoral victory was overwhelming, both the presidential and legislative. Yes, turnout was low. And yes, many voted for Macron just so that Marine Le Pen would not become president. But the fact remains that 85% of the seats in the National Assembly are held by pro-reform parties, including the pro-business, right-wing Les Républicains, who want even stricter reforms. Bottom Line: Our clients, colleagues, friends, and family all tell us that France will not reform. But we have seen this film before, with Germany in the 2000s and Spain in the 2010s. One day, investors will wake up and France will be more competitive. Fin. A German Election Post-Mortem The media narrative before and after the German election tells of the rise of Alternative für Deutschland (AfD), a far-right party that campaigned on an anti-EU and anti-immigration platform. Indeed, the performance of the center-right Christian Democratic Union (CDU) and center-left Social-Democratic Party (SPD), which have dominated German politics since the Second World War, was historically poor (Chart 9). Chart 9Germany's Dominant Parties Underperformed... Is There Anything Left To Say About Europe? Is There Anything Left To Say About Europe? Despite the media hysterics, there were no surprises this year. The AfD performed in line with its polls, only outperforming their long-term polling average by around 2%. Meanwhile, the historic underperformance of the CDU and SPD was also due to the solid performance of the other two establishment parties, the liberal Free Democratic Party (FDP) and the center-left Greens (Chart 10). The FDP stormed back into the Bundestag by more than doubling their performance from 2013, while the Greens maintained their roughly 9% performance. Die Linke, a left-wing party whose Euroskeptic tendencies have dissipated, also gained around 9% of the vote. From a historical perspective, the combined CDU and SPD performance was bad, but roughly in line with their 2009 election result. Chart 10... While Minor Parties Outperformed Is There Anything Left To Say About Europe? Is There Anything Left To Say About Europe? That said, there was no once-in-a-lifetime global recession this time around to excuse the poor performance of the two establishment parties. German GDP growth is set to be 2.1% in 2017 and the unemployment rate is at a historic 3.7%. Meanwhile, support for the euro is at 81% (Chart 11), which begs the question of why 12.6% voters decided to entrust AfD with their votes. Chart 11Germans Love The Euro Germans Love The Euro Germans Love The Euro The simple answer is immigration and the 2015 asylum crisis. The more complex answer is that AfD's performance was particularly strong in East Germany, where the party is now the second largest after the CDU. The same forces that fueled the Brexit referendum and the election of President Donald Trump are at work in Germany. Voters who feel left behind by the transition to a globalized, service-oriented economy have rebelled against a system that favors the educated and mobile voters. In Germany, the angst is particularly notable in the East, where economic progress has lagged that of the rest of the country. On the other hand, it is ludicrous to compare AfD to Brexit and Trump. After all, AfD received only 12% of the vote. This is in line with, or slightly trails, the performance of other right-wing parties in Europe (Chart 12). Yes, it is disturbing to see a far-right party back in the Bundestag, but it was also naïve to believe that Germany could remain a European outlier forever. In fact, like other right-wing parties in Europe, the party is beset with internal rivalries. Party chairwoman Frauke Petry, who represents the moderate wing of the party, decided to quit one day after the election.3 We would suspect that the party will struggle going forward, particularly now that the influx of asylum seekers has trickled down to insignificance (Chart 13). Chart 12German Far Right Performed In Line With Other European Anti-Establishment Parties Is There Anything Left To Say About Europe? Is There Anything Left To Say About Europe? Chart 13Refugee Crisis Is Over In Germany And Europe Refugee Crisis Is Over In Germany And Europe Refugee Crisis Is Over In Germany And Europe Going forward, Chancellor Angela Merkel will retain her hold on power. However, she will likely have to do so via a "Jamaica coalition" with the FDP and the Greens.4 Forming such a challenging coalition could take until the New Year. Particularly problematic are the positions of the FDP and the Greens on Europe. The former are mildly Euroskeptic, the latter are rabidly Europhile. Merkel's 2009-13 coalition with the FDP was similarly challenging. The FDP moved towards soft Euroskepticism after the Great Financial Crisis. It combined with CDU's Bavarian sister party - the Christian Social Union (CSU)5 - to vote against a number of European rescue efforts and institutional changes (Chart 14). Merkel had to rely on the opposition SPD, which is staunchly Europhile, to push several European reforms through the Bundestag. More broadly, both the FDP and the CSU were a brake on Merkel during this period, leading to Berlin's halting response to the Euro Area crisis. Chart 14The FDP Hampered German Rescue Efforts Amid Euro Crisis Is There Anything Left To Say About Europe? Is There Anything Left To Say About Europe? Going forward, a Jamaica coalition is investment-relevant for three reasons: First, it would likely pour cold water on recent enthusiasm about accelerated European integration spurred by the election of President Emmanuel Macron in France. But investors should not read too much into it. As Chart 11 clearly illustrates, Germans are not Euroskeptic. The Euro Area works for Germany. If there is a future crisis, Germany will react to it in an integrationist fashion, shoving aside any coalition agreements to the contrary. And if Merkel has to rely on opposition SPD votes to push through the evolving European agenda, she will do so, regardless of what is said between now and December. Second, Merkel will have to respond to the poor performance of her party. She has to give in to the right wing on illegal immigration. Investors should expect to see tighter border enforcement on Europe's external borders. More relevant to the markets, we expect mildly Euroskeptics critics in her own party, as well as in the FDP and CSU, to be satisfied by officially pushing for Jens Weidmann's presidency at the ECB. Weidmann has recently toned down his criticism of ECB policies - publically defending low interest rates - which is likely a strategy to make himself palatable as the next president. Third, it is widely being discussed that the FDP will demand the finance ministry from Merkel, replacing Wolfgang Schäuble. This would definitely complicate any future efforts to deal with Euro Area sovereign debt crises, were they to emerge. However, the FDP is making a mistake. If they take the finance portfolio, they will be signing off on bailouts in the future. That is a guarantee. Europe is full of moderately Euroskepic finance ministers who have done the same (see: Austria, Finland, and the Netherlands in particular). Finally, the election was a clear failure by Merkel to defend her brand. While she has not signaled a willingness to resign, it is highly likely that she will try to groom her successor over the next four years. The 63 year-old has been in power since 2005. At the moment, the list of potential names for CDU leadership is long, but devoid of star power (Box 1). The one quality of all the potential candidates, however, is that they are pro-Europe. Bottom Line: In the short term, markets have read German elections overly negatively. The euro reacted on the news as if the currency bloc breakup risk premium had risen. It hasn't. In fact, the election could prove to be a long-term bullish euro outcome, given that Merkel will likely have to acquiesce to Jens Weidmann's candidacy for the ECB presidency. The German Bundestag remains overwhelmingly pro-Europe. The now-in-opposition SPD is pro-integration, as are the likely new coalition members, the Greens. Die Linke has evolved from anti-capitalist, soft Euroskeptics to left-of-SPD Europhiles. While FDP remains committed to a mildly Euroskeptic line (pro-Europe, but opposed to further integration), its members will likely have to sacrifice this position in order to be in government in the long term. They won't say that they are doing that, but trust us, they are. The performance of Germany's populist right wing is largely in line with that of other European countries. As such, it signals that Germany is a "normal country," not that there is something particularly disturbing going on. Box 1 Likely Successors To German Chancellor Angela Merkel If Merkel decides to retire, who are her potential successors? Ursula von der Leyen (CDU): Leyen, who has served most recently as defense minister, is often cited as a likely replacement for Merkel. However, she is not seen favorably by most of the population: she has not won first place in her district in any of the past three general elections. She is a strong advocate of further European integration and has supported the creation of a "United States of Europe." Leyen has argued that the European refugee crisis and debt crisis are similar in that they will ultimately force Europe to integrate further. As a defense minister, she has promoted the creation of a robust EU army. She has also been a hardliner on Brexit, saying that the U.K. will not re-enter the EU in her lifetime. The markets and pro-EU elites in Europe would love Leyen, who handled U.S. President Trump's statements on Germany, Europe, Russia and NATO with notable tact. Thomas De Maizière (CDU): Maizière, who has served as minister of interior and minister of defense, is a close confidant of Chancellor Merkel. He was her chief of staff from 2005 to 2009. Like Schäuble, he is somewhat of a hawk on euro area issues (he drove a hard bargain during negotiations to set up a fiscal backstop, the European Financial Stability Fund, in 2010) and as such could become a compromise candidate between the Europhiles and Eurohawks within CDU ranks. Though he has been implicated in scandals as defense minister, he has remained popular by drawing a relatively hard line on immigration policy and internal security. Julia Klöckner (CDU): A CDU deputy chairwoman from Rhineland-Palatinate, Klöckner is a socially conservative protégé of Merkel and a hence a likely candidate to replace her. While remaining loyal to Merkel, she has taken a more right-wing stance on the immigration crisis. She is a staunch Europhile who has portrayed the Euroskeptic AfD as "dangerous, sometimes racist," though she has insisted that AfD voters are not all "Nazis" but are mostly in the middle of the political spectrum and need to be won back by the CDU. We think that she would be a very pro-market choice as she combines a popular, market-irrelevant wariness about immigration with a market-relevant centrism that favors further European integration. Hermann Gröhe (CDU): Gröhe last served as minister of health and is a former CDU secretary general. He is very close to Merkel. He is a staunch supporter of the euro and European integration. Markets would have no problem with Gröhe, although they may take some time to get to know who he is! Volker Bouffier (CDU): As Minister President of Hesse, home of Germany's financial center Frankfurt, Bouffier is in a position to capitalize on Brexit. He is a heavyweight within the CDU's leadership and a staunch Europhile. He has already declared he will run for the top state office again in 2018, though he will be 67 years old by then. The U.K.: Fall In Florence Prime Minister Theresa May tried to reset Brexit negotiations with the EU recently by giving a speech in Florence. We were told by clients and colleagues that it would be an important event, so we tuned in and listened. The speech was largely a dud. It confirmed to us the constraints on London's negotiating position as well as the challenges that Brexit poses to the British economy. May's team is struggling to navigate both. There are three things that investors should take from the speech - most which we have been emphasizing for over a year: The EU exit bill: The U.K. will pay. The one concrete point that Prime Minister May agreed with, for the first time ever, is that London will continue to pay into the current EU seven-year budget period (2014-2020). This should never have been in doubt. Britain's refusing to pay would be the equivalent of a tenant giving notice that he is ending his lease in 24 months, then refusing to pay in the interim. What May did not say is whether the U.K. would pay anything beyond its share of contribution to the EU budget. At the moment, the answer appears to be no, but we don't expect that to be the final word. Services really (really) matter: The U.K. has a competitive advantage in services. This is why May has tried to signal that she wants the broadest trade deal possible, since regular free trade agreements (FTAs) do not provide for deep integration in services. What will the U.K. give in return? May appears to want a Norway-type EU trade agreement with Canada-type liabilities. This won't fly in Brussels. The transition deal will last two years at minimum: This was never in doubt. But due to domestic political pressures, May was afraid of voicing it in public until today. Below we provide excerpts of the most relevant (or irrelevant, but comical) parts of May's speech.6 Our running commentary is in brackets. Theresa May's Florence Speech On Brexit, September 2017: A Reinterpretation By GPS It's good to be here in this great city of Florence today at a critical time in the evolution of the relationship between the United Kingdom and the European Union. It was here, more than anywhere else, that the Renaissance began - a period of history that inspired centuries of creativity and critical thought across our continent and which in many ways defined what it meant to be European. [GPS: Strong opening by May. Odd location for the speech, however. Unless she was looking to ingratiate herself with Matteo Renzi, former mayor of Florence, former prime minister of Italy, and current leader of the ruling Democratic Party]. * * * The British people have decided to leave the EU; and to be a global, free-trading nation, able to chart our own way in the world. For many, this is an exciting time, full of promise; for others it is a worrying one. I look ahead with optimism, believing that if we use this moment to change not just our relationship with Europe, but also the way we do things at home, this will be a defining moment in the history of our nation. [GPS: This is a crucial argument by proponents of Brexit, that leaving the EU is not just about leaving the bloc's oversight, but also about domestic renewal. At the heart of this view is the belief that the EU has shackled the U.K.'s potential economic output with its regulatory oversight and protectionist trade policies. For this to be true, the U.K. has to replace significance labor force growth - from the EU Labor Market - with even greater productivity growth. If the U.K. fails to do this, its potential GDP growth rate will be substantively lower in the future. We do not buy the optimism. For one, the EU has not been a drag on the U.K.'s World Bank Ease Of Doing Businness rankings, where the country ranks seventh. Second, several other EU member states are in the top 20, including Sweden, Estonia, Finland, Latvia, Germany, Ireland and Austria. Third, developed economies have been dealing with sub-standard productivity growth for over a decade, both EU members and non-members. As such, we are pretty certain that the U.K.'s potential GDP growth rate will be lower over the next decade, not higher.] And it is an exciting time for many in Europe too. The European Union is beginning a new chapter in the story of its development. Just last week, President Juncker set out his ambitions for the future of the European Union. [GPS: A nod to the reality that without the U.K. stalling its integration, Europe is now better able to build its "ever closer union." May is essentially conceding here to Charles de Gaulle's argument, articulated in the 1960s, that letting Britain into the club would ultimately be a mistake.]7 There is a vibrant debate going on about the shape of the EU's institutions and the direction of the Union in the years ahead. We don't want to stand in the way of that. [GPS: Reality check: it has literally been the foreign policy of the U.K. to "stand in the way of" of a united Europe for at least six hundred years ...] * * * Our decision to leave the European Union is in no way a repudiation of this longstanding commitment. We may be leaving the European Union, but we are not leaving Europe. Our resolve to draw on the full weight of our military, intelligence, diplomatic and development resources to lead international action, with our partners, on the issues that affect the security and prosperity of our peoples is unchanged. Our commitment to the defence - and indeed the advance - of our shared values is undimmed. Our determination to defend the stability, security and prosperity of our European neighbours and friends remains steadfast. [GPS: As we have argued repeatedly, the U.K. and EU share crucial geopolitical and economic links. As such, it is difficult to see negotiations devolving into the sort of acrimony that many have expected. May understands this and is reminding Europe of how important the U.K. role is, and will continue to be, geopolitically for Europe.] * * * The strength of feeling that the British people have about this need for control and the direct accountability of their politicians is one reason why, throughout its membership, the United Kingdom has never totally felt at home being in the European Union. [GPS: A not-so-slight dig at Europe. Basically, May is saying that U.K. voters live in a democracy. EU voters live in something else.] And perhaps because of our history and geography, the European Union never felt to us like an integral part of our national story in the way it does to so many elsewhere in Europe. [GPS: This is true and can be empirically measured (Chart 15).] Chart 15Brits Have A Strong Sense Of National Identity Brits And Only Brits Brits And Only Brits * * * For while the UK's departure from the EU is inevitably a difficult process, it is in all of our interests for our negotiations to succeed. If we were to fail, or be divided, the only beneficiaries would be those who reject our values and oppose our interests. [GPS: This is all true and very well put. But it also appears to be a line of argument designed to tug at Europe's emotional strings. Like a husband asking his wife to take it easy on him in a divorce "for the sake of the children."] So I believe we share a profound sense of responsibility to make this change work smoothly and sensibly, not just for people today but for the next generation who will inherit the world we leave them. [GPS: Literally the line about the kids followed immediately!] * * * But I know there are concerns that over time the rights of EU citizens in the UK and UK citizens overseas will diverge. I want to incorporate our agreement fully into UK law and make sure the UK courts can refer directly to it. Where there is uncertainty around underlying EU law, I want the UK courts to be able to take into account the judgments of the European Court of Justice with a view to ensuring consistent interpretation. On this basis, I hope our teams can reach firm agreement quickly. [GPS: An important concession - the first in the speech so far, and we are more than halfway through: London will apparently take into account ECJ rulings when dealing with EU citizens living in the U.K. That is a huge concession to Europe and an arrangement unlike anywhere else in the world.] * * * The United Kingdom is leaving the European Union. We will no longer be members of its single market or its customs union. For we understand that the single market's four freedoms are indivisible for our European friends. We recognise that the single market is built on a balance of rights and obligations. And we do not pretend that you can have all the benefits of membership of the single market without its obligations. [GPS: As we have said in the past, May's decision to concede this point in January was a major concession to the EU and is the reason that the negotiations are not and will not be acrimonious. If the U.K. demanded access to the Common Market without accepting the "four freedoms," it would have received an acrimonious response, given that its request would have been construed as "special treatment."] So our task is to find a new framework that allows for a close economic partnership but holds those rights and obligations in a new and different balance. But as we work out together how to do so, we do not start with a blank sheet of paper, like other external partners negotiating a free trade deal from scratch have done. In fact, we start from an unprecedented position. For we have the same rules and regulations as the EU - and our EU Withdrawal Bill will ensure they are carried over into our domestic law at the moment we leave the EU. [GPS: May is correct. The EU-U.K. trade negotiations should be relatively smooth given that the U.K. is not starting from scratch in negotiating the relationship. The Canada-EU FTA took seven years because they were starting from scratch.] So the question for us now in building a new economic partnership is not how we bring our rules and regulations closer together, but what we do when one of us wants to make changes. One way of approaching this question is to put forward a stark and unimaginative choice between two models: either something based on European Economic Area membership; or a traditional Free Trade Agreement, such as that the EU has recently negotiated with Canada. I don't believe either of these options would be best for the UK or best for the European Union. European Economic Area membership would mean the UK having to adopt at home - automatically and in their entirety - new EU rules. Rules over which, in future, we will have little influence and no vote. [GPS: We pointed out why such an arrangement would be illogical in March 2016. Essentially, the U.K. would leave the EU due to its onerous regulation and infringement on sovereignty only to accept the onerous regulation as a fait accompli with no room for British sovereignty (Diagram 1)!] Diagram 1The Central Paradox Of Brexit Is There Anything Left To Say About Europe? Is There Anything Left To Say About Europe? Such a loss of democratic control could not work for the British people. I fear it would inevitably lead to friction and then a damaging re-opening of the nature of our relationship in the near future: the very last thing that anyone on either side of the Channel wants. As for a Canadian style free trade agreement, we should recognise that this is the most advanced free trade agreement the EU has yet concluded and a breakthrough in trade between Canada and the EU. But compared with what exists between Britain and the EU today, it would nevertheless represent such a restriction on our mutual market access that it would benefit neither of our economies. [GPS: This is, by far, the most critical part of May's speech. She is essentially saying that a Canadian FTA deal would benefit the EU more than it benefits the U.K., a point we have made for nearly two years now. This is true. The U.K. needs access to the EU services market, where British exporters have a comparative advantage. Were they to secure an FTA deal with the EU instead, they would be giving Europe a massive advantage, given the bloc's comparative advantage in tradable goods (Chart 16). However, this takes us back to Diagram 1. What kind of a relationship does May expect to get from the EU when she is unwilling to accept any of the liabilities inherent in such a deep trade deal? That is precisely what the Common Market is for.] Chart 16Brexit Hinders U.K.'s Comparative Advantage Brexit Hinders U.K.'s Comparative Advantage Brexit Hinders U.K.'s Comparative Advantage Bottom Line: Prime Minister May's Florence speech has shown the limits of the U.K.'s negotiating position. May set a friendly tone with Europe, but she has nothing to bargain with. Much of the speech reiterated British commitment to Europe's security and its capacity to defend the continent from external threats. In exchange, May argues, the U.K. ought to receive the deepest and most expansive access to the EU Common Market without any of the liabilities that go with it. In particular, she wants access to the EU's services market, where U.K. exporters have a comparative advantage. The problem with the tradeoff between U.K. geopolitical benefits and EU economic benefits is that it suggests that London has an alternative to being a geopolitical ally to Europe! As if it could suddenly shift its geopolitical, military, and diplomatic focus elsewhere. Berlin, Brussels, and Paris will call London's bluff. The U.K. is not in North America, it is in Europe. As such, Europe's problems are the U.K.'s problems, and the U.K. must defend against them even if it receives little in return. We expect the U.K. to succumb to the reality that the EU holds most of the cards in the negotiations. The U.K. will have a lower potential GDP growth rate after Brexit. But before Brexit is solidified, we expect considerable domestic political upheaval. In the short term, there is some upside for the pound. In the long term, it is a sell. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com 1 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy and Foreign Exchange Strategy Special Report, "The French Revolution," dated February 3, 2017, available at gps.bcaresearch.com. 3 Although she has herself played a role in kicking out the original, even more moderate, founders of the party. 4 The CDU, FDP, and Greens coalition is dubbed the "Jamaica coalition" because of their traditional colors - black, yellow, and green - which combine to make the colors of the Jamaican flag. 5 The CSU does not directly compete against the CDU on the federal level. It only fields candidates in Bavaria, where the CDU does not compete. 6 For the full transcript, please see "Theresa May's Florence speech on Brexit, full text," The Spectator, September 22, 2017, available at blogs.spectator.co.uk. 7 In turn, this will allow the EU to build up its power, develop a navy, and finally conquer the British Isles with a new armada somewhere around 2066! Geopolitical Calendar

Highlights In this Weekly Report, we present our semi-annual chartbook of the BCA Central Bank Monitors - one of our favorite and long-standing indicators to assess the potential for monetary policy changes. The broad conclusion - the Monitors are all at or above the threshold signaling that tighter monetary policy is required, validating the recent hawkish shift by policymakers. Feature September has been an active month for central bankers. The Bank of Canada hiked rates again, the European Central Bank gave strong hints that a tapering of its asset purchase program will soon be announced, and the Bank of England warned that tighter policy might soon be required. Just last week, the Federal Reserve began the process of reducing its massive balance sheet while also making no changes to its plans to hike interest rates several times over the next year. This is setting up a potential nasty surprise for bond markets. Investors have became deeply skeptical about the possibility of policymakers shifting in a more hawkish direction without an obvious trigger from faster inflation. Yet the global economy is in a synchronized expansion with the largest share of countries operating at (or beyond) full employment since the pre-crisis years. Inflation is in the process of stabilizing, or grinding higher, in most of the major economies. In this Weekly Report, we present our semi-annual chartbook of the BCA Central Bank Monitors - one of our favorite indicators to assess the potential for monetary policy changes. The broad conclusion - the Monitors are all at or above the threshold signaling that tighter policy is required, validating the recent hawkish shift by policymakers (Chart of the Week). Chart of the WeekGrowing Pressures To Tighten, According To Our Central Bank Monitors Growing Pressures To Tighten, According To Our Central Bank Monitors Growing Pressures To Tighten, According To Our Central Bank Monitors An Overview Of The BCA Central Bank Monitors Chart 2Upward Pressure On Global Bond Yields Upward Pressure On Global Bond Yields Upward Pressure On Global Bond Yields The BCA Central Bank Monitors are composite indicators designed to measure the cyclical growth and inflation pressures that can influence future monetary policy decisions. The economic data series used to construct the Monitors are not the same for every country, but the list of indicators generally measure the same things (i.e. manufacturing cycles, domestic demand strength, commodity prices, labor market conditions, exchange rates, etc). The data series are standardized and combined to form the Monitors. Readings above the zero line for each Monitor indicate pressures for central banks to raise interest rates, and vice versa. Through the nexus between growth, inflation, and market expectations of future interest rate changes, the Monitors do exhibit broad correlations to government bond yields in the Developed Markets (Chart 2). Currently, the Monitors are all near or above the zero line, providing context for why central bankers have shifted towards a more hawkish bias of late. Actual rate hikes are still not likely over the next few months outside of the Fed and BoC (we remain skeptical on the potential for the BoE to realistically tighten policy). More importantly, the underlying growth and inflation pressures indicated by the Monitors suggest that policymakers will maintain a hawkish bias (or, at best, a neutral tone) in their communications with the markets. One new addition to the individual country sections in this Chartbook are charts showing the Monitors, broken into growth and inflation components. The conclusion from these new charts is that the current level of the overall Monitors is a reflection of strong economic growth in all countries, with the inflation components giving more mixed signals. The Fed Monitor: Neutral For Now, Likely To Head Higher Again Our Fed Monitor has drifted lower over the past several months, and now sits just slightly above the zero line, calling for no imminent need to change U.S. monetary policy (Chart 3A). FOMC members have been sending more balanced messages in their recent speeches, specifically noting the confusing mix of what appears to be a U.S. economy operating at full employment but with slowing core inflation (Chart 3B). Chart 3AU.S.: Fed Monitor U.S.: Fed Monitor U.S.: Fed Monitor Chart 3BNo Spare Capacity In The U.S. No Spare Capacity In The U.S. No Spare Capacity In The U.S. When looking at the breakdown of our Monitor into its main inputs (Chart 3C), the growth component remains in a steady grinding uptrend. The inflation component had softened since the peak earlier this year, but the latest reading shows a slight uptick. Chart 3CPressure On The Fed From U.S. Growth. Is Inflation Next? Pressure On The Fed From U.S. Growth. Is Inflation Next? Pressure On The Fed From U.S. Growth. Is Inflation Next? Looking ahead, we expect realized U.S. inflation, which looks to be stabilizing after the downturn since the spring, to grind higher alongside a steadily expanding U.S. economy. With corporate profits and household incomes expanding, and with leading indicators steadily climbing, there is little reason to expect much sustained slowing of U.S. growth in the next few quarters. The next move in our Fed Monitor will likely be upward. The historical correlations between changes in our Fed Monitor and changes in U.S. Treasury yields suggest that any renewed increase in the Monitor should put more upward pressure on the front end of the yield curve than the back end (Chart 3D). This suggests that Treasury curve would bear-flatten as the market priced in more Fed rate hikes. However, we see a greater near-term risk of a bear-steepening of the curve given the low level of market-based inflation expectations. The Fed will want to see those rise - which will require signs of realized inflation rebounding - before delivering another rate hike, perhaps as soon as December. Chart 3DThe Fed Monitor Is Most Correlated To Shorter-Maturity USTs The Fed Monitor Is Most Correlated To Shorter-Maturity USTs The Fed Monitor Is Most Correlated To Shorter-Maturity USTs BoE Monitor: The Window Is Closing For A Rate Hike Our Bank of England (BoE) Monitor has been in the "tight money required" zone since the end of 2015 and has not signaled a need for easier monetary policy since 2012 (Chart 4A). This is unsurprising with the U.K. economy running beyond full employment for over three years alongside a steady rise in inflation (Chart 4B). Chart 4AU.K.: BoE Monitor U.K.: BoE Monitor U.K.: BoE Monitor Chart 4BTight Capacity In The U.K. Tight Capacity In The U.K. Tight Capacity In The U.K. The after-effects of the Brexit vote last year are still an issue for the U.K. economy and the BoE. The central bank eased monetary policy (rate cuts and QE) after the Brexit shock as insurance against the massive economic uncertainty. Yet that not only provided stimulus to an economy that was already operating beyond full employment, but also resulted in a 16% peak-to-trough decline in the British Pound. The result: a surge in headline U.K. inflation to 2.9%, well above the BoE's 2% target. The BoE sent a hawkish message at the policy meeting earlier this month, signaling that interest rates would have to rise if growth evolves in line with their forecasts. We are skeptical on that front: U.K. leading economic indicators have rolled over, real income growth has stagnated due the high inflation, and business confidence continues to be dragged down by Brexit uncertainties. Also, the greater stability in the trade-weighted Pound - now essentially flat versus year-ago levels - should result in some cooling off of the currency-driven surge in inflation, which the inflation component of our BoE Monitor is already signaling (Chart 4C). Chart 4CThe Inflation Component Of The BoE Monitor Has Collapsed The Inflation Component Of The BoE Monitor Has Collapsed The Inflation Component Of The BoE Monitor Has Collapsed We remain neutral on Gilts, as we expect the BoE to remain on hold and not follow through on their recent hawkish commentary (Chart 4D). Chart 4DThe Gilt/BoE Monitor Correlations Are Higher At The Long-End The Gilt/BoE Monitor Correlations Are Higher At The Long-End The Gilt/BoE Monitor Correlations Are Higher At The Long-End ECB Monitor: On Course For A 2018 Taper Our European Central Bank (ECB) Monitor has steadily climbed over the course of 2017 and now sits right on the zero line (Chart 5A). The solid and broad-based economic expansion in the Euro Area has soaked up spare capacity. The unemployment rate has fallen to an 8-year low of 9.1%, suggesting that the Euro Area economy is very close to full employment for the first time since the Great Recession (Chart 5B). Chart 5AEuro Area: ECB Monitor Euro Area: ECB Monitor Euro Area: ECB Monitor Chart 5BExcess Capacity In Europe Dwindling Fast Excess Capacity In Europe Dwindling Fast Excess Capacity In Europe Dwindling Fast Against that strong growth backdrop, core inflation has been grinding higher off the lows, but at 1.4% remains below the ECB 2% target for headline inflation. When looking at the components of our ECB Monitor, however, rising inflation pressures have been as important a reason behind the pickup in the Monitor as stronger growth (Chart 5C). Chart 5CGrowth Has Pushed The ECB Monitor Higher This Year Growth Has Pushed The ECB Monitor Higher This Year Growth Has Pushed The ECB Monitor Higher This Year The deflation threat that prompted the ECB to begin its own asset purchase program in 2015 has passed, and we expect the ECB to announce a tapering of the bond buying starting in January 2018. If growth and inflation evolve according to the ECB's forecasts - which is likely barring an additional major surge in the euro from current elevated levels - then there is a good chance that the asset purchase program will be wound down by the end of 2018. Interest rate hikes are still some time away, though. The market is currently discounting a first 25bp ECB rate hike around October 2019. We agree with that pricing, as the ECB will "follow the Fed playbook" and not begin rate hikes until well after the end of the asset purchase program. We remain underweight Euro Area government debt, with a bias towards bear-steepening of yield curves as inflation expectations should steadily climb higher and the ECB keeps policy rates unchanged (Chart 5D). Chart 5DStronger Bond/ECB Monitor Correlations At The Short-End Stronger Bond/ECB Monitor Correlations At The Short-End Stronger Bond/ECB Monitor Correlations At The Short-End BoJ Monitor: Creeping Higher, Surprisingly The Bank of Japan (BoJ) Monitor has steadily climbed throughout 2017 and now sits right on the zero line (Chart 6A). While overall inflation rates remain well below the 2% BoJ target, the steady economic expansion has absorbed spare economic capacity, with the unemployment rate now down to a mere 2.8% (Chart 6B). Both the growth and inflation components of our BoJ Monitor have been rising (Chart 6C). Chart 6AJapan: BoJ Monitor Japan: BoJ Monitor Japan: BoJ Monitor Chart 6BTight Labor Market, But Still No Inflation Tight Labor Market, But Still No Inflation Tight Labor Market, But Still No Inflation While the pickup in inflation off the lows is a welcome sight for the BoJ, there is no immediate pressure to shift to a less accommodative policy stance (Chart 6D). In fact, the central bank has already done its own version of a "taper" by moving to a 0% yield target on JGBs one year ago. Maintaining that yield level has required a slower pace of asset purchases by the central bank, which are running at an annualized pace of 70 trillion yen so far in 2017, below the 80 trillion yen target for the current QE program. Chart 6CTight Labor Market, But Still No Inflation Tight Labor Market, But Still No Inflation Tight Labor Market, But Still No Inflation We do not see the BoJ abandoning the 0% yield target anytime soon. By depressing JGB yields, the BoJ hopes to engineer additional weakness in the yen which will feed through into faster inflation and rising inflation expectations. This appears to be the only way to generate any inflation in Japan, even with such a low unemployment rate. Chart 6DLow Correlations Between the BoJ Monitor & JGB Yields Low Correlations Between the BoJ Monitor & JGB Yields Low Correlations Between the BoJ Monitor & JGB Yields It will require a rise in Japanese core inflation back towards 2% before the BoJ will even begin to discuss any real tapering of its QE program. Thus, JGBs will remain a low-beta "safe-haven" among Developed Market government bonds, where there is greater risk of central bank tightening actions that will push yields higher. Remain overweight. BoC Monitor: More Tightening To Come The Bank of Canada (BoC) Monitor has been comfortably above the zero line throughout 2017 (Chart 7A). The Canadian economy has shown robust growth, which has soaked up spare capacity (Chart 7B). The BoC is projecting that the output gap in Canada will likely be fully closed before the end of this year. The surprising surge in growth is likely to continue given the strength in the leading economic indicators and the robust readings from the BoC's own Business Outlook Survey. Chart 7ACanada: BoC Monitor Canada: BoC Monitor Canada: BoC Monitor Chart 7BStill Not Much Inflation In Canada Still Not Much Inflation In Canada Still Not Much Inflation In Canada The central bank has already responded to the faster-than-expected pace of growth with two 25bps rate hikes since July. This took place even without much of a pick-up in realized inflation or in the inflation component of our BoC Monitor (Chart 7C). Clearly, the BoC is focusing more on the rapidly accelerating economy, with real GDP growth surging to a 3.7% year-over-year pace in Q2. With the BoC Overnight Rate still at a very low level of 1%, well below the central bank's own estimate of the neutral "terminal" rate of 3%, there is room for additional rate hikes as long as growth remains robust. Chart 7CRising Growth Pressures On The BoC, Still No Inflation Rising Growth Pressures On The BoC, Still No Inflation Rising Growth Pressures On The BoC, Still No Inflation The surging Canadian dollar is not yet a concern for the BoC, as this reflects both the improving Canadian economy and the Fed taking a pause on its own rate hiking cycle. With the latter poised to resume in December and continue into 2018, the appreciation of the "Loonie" is likely to cool off, even if the BoC keeps raising rates. We have maintained an underweight stance on Canadian bonds, with a curve flattening bias, since mid-year (Chart 7D). We are sticking with that stance, even with the market now priced for nearly 70bps of additional rate hikes over the next year. If the Canadian economy continues to grow rapidly, and the Fed returns to hiking rates, the BoC can tighten to levels beyond current market pricing. Chart 7DA Rising BoC Monitor Typically Leads To A Flatter Canadian Yield Curve A Rising BoC Monitor Typically Leads To A Flatter Canadian Yield Curve A Rising BoC Monitor Typically Leads To A Flatter Canadian Yield Curve RBA Monitor: Conflicting Forces Our Reserve Bank of Australia (RBA) Monitor remains in "tighter policy required" territory (Chart 8A). Core inflation has picked up slightly, dragging market expectations along with it, but headline price growth has declined below 2% (Chart 8B). However, commodity prices continue to ease, survey-based measures of inflation expectations have pulled back and the inflation component of the RBA Monitor has retreated from the highs (Chart 8C). Chart 8AAustralia: RBA Monitor Australia: RBA Monitor Australia: RBA Monitor Chart 8BNo Inflation Pressures On The RBA No Inflation Pressures On The RBA No Inflation Pressures On The RBA The RBA is facing conflicting forces of an improving labor market and booming house prices, combined with high consumer indebtedness and nonexistent real wage growth. Though employment growth has recently spiked, part time employment as a percentage of total is just starting to roll over and underemployment remains elevated. Labor market conditions will need to tighten considerably for wages to rise and consumer confidence to recover. A wide output gap, mixed employment backdrop and a lack of inflation pressure will likely keep the policymakers on hold for longer than the market expects. Chart 8CRBA Facing Surging Growth Pressures & Cooling Inflation Pressures BCA Central Bank Monitor Chartbook: The Less Dovish Rhetoric Is Justified BCA Central Bank Monitor Chartbook: The Less Dovish Rhetoric Is Justified We are currently at a neutral stance on Australian government bonds, given the mixed economic backdrop. Instead, we prefer to maintain our 2yr/10yr yield curve flattener trade. The short end will remain anchored by an inactive RBA, with the long end facing downward pressure from soft inflation expectations and macro-prudential measures in the housing market dampening credit growth. Even if the RBA were to tighten policy as markets expect, the yield curve would flatten. Additionally, negative correlations between Australian yield curves and the RBA monitor have been more robust in the post-crisis era (Chart 8D). As labor markets continue to improve, the other components of the Monitor, such as wages, retail sales and consumer confidence, will follow. Chart 8DThe Entire Australian Curve Is Highly Correlated To Our RBA Monitor The Entire Australian Curve Is Highly Correlated To Our RBA Monitor The Entire Australian Curve Is Highly Correlated To Our RBA Monitor RBNZ Monitor: Rate Hikes Are Needed Our Reserve Bank of New Zealand (RBNZ) Monitor has been the strongest of all our Monitors, and is currently well into "tight money required" territory" (Chart 9A). The solid New Zealand economic expansion has fully absorbed spare capacity, and both headline core inflation are accelerating towards the RBNZ target (Chart 9B). Both the inflation and growth components are surging, contributing to the overall sharp rise in the RBNZ Monitor (Chart 9C). Chart 9ANew Zealand: RBNZ Monitor New Zealand: RBNZ Monitor New Zealand: RBNZ Monitor Chart 9BFull Employment & Rising Inflation In NZ Full Employment & Rising Inflation In NZ Full Employment & Rising Inflation In NZ So with growth and inflation looking perkier, why has the RBNZ not delivered on rate hikes this year? They central bank has highlighted "international uncertainties" related to geopolitical risks as well as trade tensions between China and the U.S. that could spill over into New Zealand exports to Asia. The central bank has also shown caution in its own growth and inflation forecasts, despite the signs of strength. Chart 9CHow Much Longer Can The RBNZ Ignore This? How Much Longer Can The RBNZ Ignore This? How Much Longer Can The RBNZ Ignore This? More likely, the RBNZ has been actively trying to avoid an unwanted surge in the currency that could derail the economy. Given the elevated geopolitical tensions with North Korea, it is likely that the RBNZ will stick with a dovish message - especially given the recent pickup in the currency. We have been running long positions in New Zealand government debt versus U.S. Treasuries and German Bunds in our Tactical Overlay portfolio since May. We've been heeding the commentary of the central bank rather than our own RBNZ Monitor, although the divergence between the two is becoming unsustainable (Chart 9D). The Q3 CPI inflation report due in October will be critical to assess the RBNZ's next move. We are sticking with our recommended trades, for now. Chart 9DNZ Bonds Are Vulnerable To Current Cyclical Growth & Inflation Pressures NZ Bonds Are Vulnerable To Current Cyclical Growth & Inflation Pressures NZ Bonds Are Vulnerable To Current Cyclical Growth & Inflation Pressures Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Patrick Trinh, Associate Editor Patrick@bcaresearch.com BCA Central Bank Monitor Chartbook: The Less Dovish Rhetoric Is Justified BCA Central Bank Monitor Chartbook: The Less Dovish Rhetoric Is Justified Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Duration: As long as inflation shows signs of stabilizing during the next couple of months the Fed will lift rates again in December. Stay at below-benchmark duration and remain overweight TIPS versus nominal Treasuries. Credit Cycle: The process of corporate sector re-leveraging is well underway, but the corporate bond trade still has further to run. In fact, the second quarter decline in net leverage likely prolongs the length of time that overweight corporate bond positions will be profitable. Economy & Inflation: While households are no longer paying down debt, the pace of re-leveraging has so far been slow. With delinquency rates already starting to rise for certain classes of consumer credit, we see household debt growth as remaining tepid at best. Feature Janet Yellen struck a somewhat hawkish tone in her press conference following last week's FOMC meeting, as did the post-meeting statement and Summary of Economic Projections (SEP). Predictably, the bond market sold off and is now priced for 39 bps of rate hikes between now and the end of 2018 (Chart 1). While this is still well below the 100 bps predicted in the SEP, it proved sufficient to send the 2-year Treasury yield to a new cycle high (Chart 1, bottom panel). The Fed also announced the unwind of its balance sheet, as had been widely anticipated, and Yellen took great pains to stress that the pace of balance sheet reduction will not be altered unless the economy encounters a shock severe enough to send the fed funds rate back to zero. As was discussed in last week's report,1 this is a calculated move by the Fed meant to sever the link between the balance sheet and expectations about the future path of rate hikes. The SEP showed that most FOMC participants still expect to lift rates once more this year, and that only four out of 16 believe the Fed should stand pat, the same number as in June. However, expectations for one more hike this year are most likely contingent on inflation showing some further signs of strength. To see this, we note that the real fed funds rate is very close to at least one popular estimate of its equilibrium level (Chart 2). With inflation still below the Fed's target it is imperative that an accommodative monetary policy stance is maintained. Practically, this means keeping the real fed funds rate below equilibrium so that economic slack can be absorbed and inflation can rise. If inflation stays flat and the Fed hikes in December, then the real fed funds rate will move above the Laubach-Williams estimate of equilibrium. Chart 1Fed Pushes Yields Higher Fed Pushes Yields Higher Fed Pushes Yields Higher Chart 2Funds Rate Must Stay Below Neutral Funds Rate Must Stay Below Neutral Funds Rate Must Stay Below Neutral We calculate that if the Fed delivers a 25 basis point hike in December, then year-over-year core PCE inflation must rise from its current 1.41% to 1.63% for the real fed funds rate to stay below its neutral level (Chart 2, bottom panel). This squares with the Fed's central tendency forecast that calls for core PCE inflation between 1.5% and 1.6% by the end of the year. In our view, as long as inflation shows further signs of stabilizing and moves toward the Fed's central tendency range during the next couple of months, then the Fed will likely lift rates again in December. However, if inflation resumes its recent downtrend, then the Fed will take a pass. Inflation Expectations: Yellen vs. Brainard Perhaps the most interesting detail to emerge from last week's FOMC meeting is that the committee is so far rejecting Governor Lael Brainard's claim that inflation expectations have become unanchored to the downside. As we discussed in a recent report,2 inflation expectations are critical to the Fed's way of thinking about inflation. In the Fed's view, monetary policy can be used effectively in response to shifts in the cyclical drivers of inflation. However, if inflation expectations were to become unanchored, it would suggest that inflation's long run trend had been altered. This would make monetary policy much less effective, and a timely return of inflation to target much less likely. Governor Brainard views the recent weakness in inflation as suggesting that inflation expectations have in fact become unmoored. As evidence she points to the low levels of: TIPS breakeven inflation rates (Chart 3, top panel) Chart 3Inflation Expectations Inflation Expectations Inflation Expectations Household inflation expectations from the University of Michigan survey (Chart 3, panel 2) 5-year, 5-year forward CPI forecasts derived from the Survey of Professional Forecasters (SPF) (Chart 3, panel 3) In contrast, at her post-meeting press conference Chair Yellen pointed to median 10-year forecasts from the SPF as evidence that inflation expectations remain well-anchored (Chart 3, bottom panel). Although, she also admitted that she is unable to explain why inflation has fallen this year: I can't say I can easily point to a sufficient set of factors that explain this year why inflation has been this low. I've mentioned a few idiosyncratic things, but frankly, the low inflation is more broad-based than just idiosyncratic things. What matters for bond investors is that TIPS breakeven inflation rates, a measure of the compensation for inflation protection embedded in nominal bond yields, are well below levels that are usually seen when core inflation is well anchored around the Fed's target. At present, the 10-year TIPS breakeven inflation rate is 1.84%. We expect it will return to a range between 2.4% and 2.5% by the time that year-over-year core PCE inflation reaches 2%. In Yellen's view, inflationary pressures are strong enough for this process to play out with the Fed still being able to gradually lift rates, once more this year and then three more times in 2018. But the longer that inflation fails to rebound as Yellen expects, the more likely it becomes that the committee will come around to Brainard's view and scale back the pace of hikes. A slower expected pace of rate hikes will lend support to inflation and TIPS breakevens, and in either scenario we would expect TIPS breakevens to reach the 2.4% to 2.5% range by the end of the cycle. The uncertainty surrounds what level of real rates will be required to achieve that outcome. In that regard we are more inclined toward Yellen's view. Inflation will soon follow growth indicators higher,3 and the Fed will be able to deliver a pace of rate hikes similar to what it currently projects. But with so few rate hikes priced into the curve, we think the investment implications are the same in either scenario. Investors should stay at below-benchmark duration and remain overweight TIPS versus nominal Treasuries. Bonds In The Long-Run? The Fed's median projection for the level of longer-run interest rates also declined last week, from 3% to 2.75%. It is now only 8 bps above the 5-year, 5-year forward Treasury yield (Chart 4). Chart 4Fed Slowly Embracing A Low Neutral Rate Fed Slowly Embracing A Low Neutral Rate Fed Slowly Embracing A Low Neutral Rate In general, we think the 5-year, 5-year Treasury yield should be equal to the nominal interest rate expected to prevail in the longer-run plus a small risk premium. In that respect, the yield still looks a tad low compared to the Fed's forecast, although the gap has narrowed considerably. While we would not want to hinge our investment strategy on the accuracy of the Fed's longer-run interest rate forecast, it is notable that the Fed continues to price-in a future where the equilibrium interest rate remains depressed. Please see the Economy & Inflation section (below) for a discussion of the longer-run outlook for the fed funds rate. Corporate Credit Cycle Prolonged Second quarter Financial Accounts (formerly Flow of Funds) data were released last week, allowing us to update some of our credit cycle indicators. Chart 5 shows that, historically, three conditions must be met before the credit cycle turns and we experience a period of sustained corporate bond underperformance. Our Corporate Health Monitor (CHM) must be in "deteriorating health" territory, signaling that the corporate sector is aggressively taking on debt (Chart 5, panel 2). Monetary policy must be restrictive. This can be signaled by the real federal funds rate crossing above its equilibrium level (Chart 5, panel 3), or an inversion of the yield curve (Chart 5, panel 4). Banks must be tightening standards on commercial & industrial loans (Chart 5, bottom panel). So far this cycle only the first criterion has been met and while the CHM remains firmly in "deteriorating health" territory, it actually took a sizeable turn toward zero in Q2. The marginal improvement in corporate health was broad based across all six of our monitor's components (Chart 6). Even return on capital, which had been in free fall, managed to move higher (Chart 6, panel 3). Chart 5Credit Cycle Indicators Credit Cycle Indicators Credit Cycle Indicators Chart 6Corporate Health Monitor Components Corporate Health Monitor Components Corporate Health Monitor Components Box 1Corporate Health Monitor Components Won't Back Down Won't Back Down The slower pace of deterioration in corporate health can mostly be chalked up to surging profit growth. EBITD4 growth outpaced debt growth in Q2, sending our measure of net leverage lower (Chart 7). Year-over-year EBITD growth is now within striking distance of corporate debt growth for the first time since 2015 (Chart 7, bottom panel). Chart 7Can Leverage Reverse Its Uptrend? Can Leverage Reverse Its Uptrend? Can Leverage Reverse Its Uptrend? It is rare for corporate spreads to tighten while leverage is rising. So in that regard the tick lower in leverage probably extends the period of time we can remain overweight corporate bonds in a U.S. fixed income portfolio. Chart 8Profit Outlook Still Positive Profit Outlook Still Positive Profit Outlook Still Positive Since 1973, we calculate that investment grade corporate bonds have outperformed duration-equivalent Treasuries in 62% of six month periods, for an average annualized excess return of 45 bps. In prior research5 we showed that, during the same timeframe, when leverage rose for two consecutive quarters corporate bonds outperformed in only 45% of the following six month periods, for an average annualized excess return of -190 bps. This quarter's decline in leverage breaks a streak of two consecutive increases. But what about going forward? Further declines in leverage will depend on whether profit growth can sustain its recent strength. While some moderation is likely, our leading profit indicators suggest that growth will remain firm for the remainder of the year (Chart 8). Total business sales less inventories have hooked a tad lower, but are still consistent with solid profit growth (Chart 8, panel 1). Industrial production growth also rolled over last month, but that reflects temporary weakness related to Hurricane Harvey. Continued elevated readings from the ISM manufacturing index suggest that underlying demand is strong (Chart 8, panel 2). Meanwhile, dollar weakness continues to provide a tailwind for profit growth (Chart 8, panel 3), and our profit margin proxy has also ticked higher (Chart 8, bottom panel). Our profit margin proxy has risen due to weakness in unit labor costs. While tightening labor markets should cause the corporate wage bill to increase, a late-cycle rebound in productivity growth will ensure that unit labor cost growth stays muted compared to other wage growth measures. We made the case for a late-cycle rebound in productivity growth driven by stronger non-residential investment in a recent report.6 That being said, mounting wage pressures will likely cause margins to narrow next year, although a sharp margin-driven hit to profit growth is not likely in the next few quarters. Bottom Line: The process of corporate sector re-leveraging is well underway, but the corporate bond trade still has further to run. In fact, the second quarter decline in net leverage likely prolongs the length of time that overweight corporate bond positions will be profitable. Economy & Inflation: Household Re-leveraging Still A Slog As was noted above, both model-driven estimates and FOMC forecasts posit that the real equilibrium fed funds rate is very low by historical standards. One school of thought, secular stagnation, views the low equilibrium rate as a permanent state of affairs. While another, the "headwinds" thesis, claims that the fall-out from the financial crisis is keeping the equilibrium rate low for now, but that it will rise as the vestiges of the crisis start to fade. In this second theory, the major headwind keeping the equilibrium rate temporarily low would be the slow pace of household re-leveraging. Chart 9 shows the correlation between the Laubach-Williams estimate of the real equilibrium fed funds rate and growth in household debt. Household debt has only recently started to increase, and even today it is growing at a historically slow pace. So far this has not translated into strong enough growth to push the equilibrium interest rate higher, perhaps because the modest debt growth is occurring off quite a low base. Overall household debt is no longer falling relative to disposable income, but it has also not yet started to rise (Chart 9, panel 2). Whether you fall into the secular stagnation or headwinds camp, we would argue that the pace of household re-leveraging will remain tepid, keeping a lid on the equilibrium interest rate for quite some time. Household debt is dominated by housing, where still-tight lending standards and a lack of savings on the part of potential first-time homebuyers remain semi-permanent features of the economic landscape that will take a long time to disappear. Outside of housing, consumers have been adding debt fairly aggressively, especially in the non-revolving (auto loan and student loan) spaces (Chart 9, bottom panel). The problem is that in those areas where consumers have been adding debt (credit cards, auto loans and student loans), we are also seeing delinquency rates start to rise (Chart 10). Chart 9Household Debt & The Neutral Rate Household Debt & The Neutral Rate Household Debt & The Neutral Rate Chart 10Consumer Credit Delinquency Rates Consumer Credit Delinquency Rates Consumer Credit Delinquency Rates Delinquency rates are elevated compared to pre-crisis levels for both auto loans and student loans. For credit cards, where the re-leveraging is not as far advanced, delinquency rates remain low but have started to increase. It is only in the mortgage market, where re-leveraging has not occurred, that delinquencies remain low. The fact that delinquency rates have already started to increase for auto loans, student loans and credit cards suggests that there is limited scope to add further debt in those areas. Bottom Line: While households are no longer paying down debt, the pace of re-leveraging has so far been slow. With delinquency rates already starting to rise for certain classes of consumer credit, we see household debt growth as remaining tepid at best. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "The Great Unwind", dated September 19, 2017, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "Open Mouth Operations", dated September 12, 2017, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "Open Mouth Operations", dated September 12, 2017, available at usbs.bcaresearch.com 4 Earnings before interest, taxes and depreciation. 5 Please see U.S. Bond Strategy Weekly Report, "Low Inflation And Rising Debt", dated June 13, 2017, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "Open Mouth Operations", dated September 12, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights The Fed will shrink its balance and is determined to raise rates. Implications of synchronized global growth and global NAIRU. Consumers are upbeat and ready to spend. What's the signal from record high consumer expectations for equities? Feature Risk assets and Treasury yields rose up to and after last week's Fed meeting, but late-week saber-rattling by North Korea left most asset classes little changed on the week. The U.S. economic data released last week continued to be impacted by Hurricanes Harvey and Irma, but the Fed notes that the storms are "unlikely to materially alter the course of the national economy beyond the next few months". The backdrop has turned more bearish for bonds even before the Fed's recommitment last week to raising rates gradually and shrinking its balance sheet. The Fed's hawkish stance short term and dovish stance long term will allow risk assets to outperform Treasury bonds and cash, but a sudden move higher in inflation would challenge that view. FOMC: Short Term Hawkish... The Fed sent a hawkish short-term signal on the outlook for monetary policy at its meeting last week. The vast majority of FOMC members, 12 out of 16, expect to raise rates again by December (Chart 1). A 0.2% downward revision to the Fed's 2017 core PCE inflation forecast was offset by an equal 0.2% upward revision to its GDP growth forecast. Moreover, Fed Chair Janet Yellen downplayed this year's soft inflation figures and stressed that inflation expectations remain "reasonably well anchored". Although the relationship may have weakened somewhat recently, the Fed is loath to throw the Phillips curve model into the dust bin just yet. The unemployment rate forecasts were lowered from 4.2% to 4.1% for 2018 and 2019, while the Fed kept its NAIRU estimate at 4.6%. The tightening labor market is expected to place upward pressure on wage inflation and push PCE inflation to the 2% target by 2019. Chart 1Market Expects A Hike In December Market Expects A Hike In December Market Expects A Hike In December Incoming data on actual inflation and inflation expectations will determine whether the Fed will be able to pull the trigger in December. Further softness in the core PCE inflation and CPI will raise doubts as to whether the inflation undershoot is indeed transitory. And especially worrisome will be a decline in inflation expectations. It is noteworthy that 10-year inflation breakevens fell nearly 4bps immediately following yesterday's FOMC announcement. At 1.85%, 10-year breakevens are already running below the 2.4-2.5% range that is consistent with the Fed's 2% target for PCE inflation. Any further decline in breakevens will call into question the Fed's view that inflation expectations remain well anchored. Further, with the decline in inflation expectations, the 2/10-year yield curve flattened following the Fed's announcement. This is could be considered a sign of a slight lowering in growth expectations. Finally, there was little surprise on the Fed's balance sheet announcement. For now, the Fed is committed to slowly unwinding its bond holdings. Janet Yellen said that the Fed will only resume full reinvestment of maturing bonds after it had cut the policy rate back to the zero bound. In other words, the Fed funds rate is now the primary tool to set monetary policy. The odds of another Fed rate hike by year-end have certainly increased (Chart 1). This need not upset risk assets if the incoming data justify higher rates. Only a policy error, where the Fed hikes rates even as inflation expectations decline and the yield curve flattens, will trigger a sizeable pullback in risk assets. This is not our baseline scenario. Softness in inflation and inflation expectations will force the Fed to back down. ...But Long Term Dovish Although the Fed signaled a greater probability of an interest rate hike in the near-term, it lowered the long-run outlook for policy rates. First, the median FOMC member now expects only two rate increases in 2019, down from three in the June forecast (not shown). Second, the estimate for the terminal rate was lowered to 2.75% from 3.0% (Chart 2, panel 4). With the long-run inflation target being 2% (Chart 2, panel 3), this means that the FOMC collectively believes the long-term neutral real Fed funds rate to be just 0.75%. Currently, the Laubach-Williams estimate of the neutral real Fed funds rate is near zero (Chart 3). Therefore, the FOMC sees it rising only modestly from current levels over the coming years. Chart 2The FOMC's "Long Run" Forecasts Since 2012 The FOMC's "Long Run" Forecasts Since 2012 The FOMC's "Long Run" Forecasts Since 2012 Chart 3Neutral Real Rate Near Zero Neutral Real Rate Near Zero Neutral Real Rate Near Zero For any given term premium, a lower short-term interest rate path will mean a lower 10-year yield. If estimates for the terminal policy rate outside the U.S. remain unchanged, the Fed's lower projection will mean narrower interest rate differentials, reducing the relative attractiveness of the dollar. As for equities, a lower estimate for the long-run policy rate would be a wash if it also reflected a lower estimate for long-term GDP growth. However, the Fed kept its longer run real GDP growth estimate unchanged at 1.8% (Chart 2, panel 1). If that proves accurate, lower interest rates and a weaker dollar will be more supportive for U.S. equities over the long-term. Notably, the Fed did not adjust its view of NAIRU, keeping it at 4.6%, where it has been since April (Chart 2, panel 2). Bottom Line: In terms of investment implications, the lower estimate of the long-run neutral rate is supportive for 10-year Treasuries, negative for the dollar and positive for equities. Stay overweight stocks versus bonds and short duration. Don't Downplay NAIRU Synchronous global growth remains in place in 2017 and will persist into 2018, but this growth alone may not be enough to push up inflation. BCA's OECD Real GDP Diffusion Index is at 100% after it dipped to 14% during the financial crisis. The index was also above 90% from 1994 through 1998, and then again from 2001 through 2007. Moreover, the OECD expects that GDP growth will climb above zero in all the member countries in BCA's diffusion index again in 2018. The broad-based global GDP growth has historically been associated with a rising stock-to-bond ratio, rising global trade flows, a narrowing output gap and accelerating industrial production (Chart 4). However, there is no consistent pattern on the dollar, the unemployment rate, or core inflation. Chart 5 shows that during prior periods of robust global growth, equities beat bonds, the U.S. output gap tightened and industrial production increased. U.S. exports tend to contribute more to GDP growth during these phases, but not in a uniform way. Meantime, the Fed has both raised and lowered rates during these periods. Chart 4Widespread##BR##Global Growth... Widespread Global Growth... Widespread Global Growth... Chart 5... Supports Risk Assets,##BR##Trade And A Narrower Output Gap ... Supports Risk Assets, Trade And A Narrower Output Gap ... Supports Risk Assets, Trade And A Narrower Output Gap Nonetheless, while the dollar jumped in the 1990s when BCA's OECD growth index was above 90%, it fell from 2001 to 2007, and it's performance since 2015 has been mixed. The unemployment rate declined in the mid-to-late 1990s, but initially rose in the 2001-2007 period and has dropped since 2010. The Fed both raised and lowered rates during the previous episodes, but has only boosted rates in the current phase. Core inflation slowed in the 1990s when 90% of countries saw positive GDP growth, but accelerated in the early 2000s. Since 2015, core inflation has both climbed and decelerated. What will trigger higher inflation if more than 90% of the globe is experiencing positive economic growth? BCA's Global Fixed Income Strategy service notes that1 67% of OECD nations have unemployment rates under the organization's assessment of "global NAIRU", a level not seen since before the Great Recession when inflation expanded in both the goods and service sectors (Chart 6). However, the link between inflation and NAIRU waned during and just after the 2007-2009 recession and only reconnected lately. The implication for investors is that there is a global NAIRU level (or global output gap), which is more important in determining worldwide inflation rates than individual country NAIRU measures. Chart 6The NAIRU Concept Is Not Dead Yet The NAIRU Concept Is Not Dead Yet The NAIRU Concept Is Not Dead Yet Bottom Line: Surging global growth is a precondition for higher inflation, but sustained improvement in the labor market is needed to drive up inflation and prompt more action from the Fed. Investors may be downplaying the NAIRU concept at a time when it is finally set to bite. If that is the case, inflation expectations around the world are too low, although it will take some evidence of faster realized inflation (especially in the U.S. and Europe) before the markets begin to discount that view in bond yields. Stay underweight duration. Flow Of Funds Update On Consumer And Corporate Health The latest readings on the health of household and corporate balance sheets from the Fed's flow of funds accounts reinforce BCA's stance that consumer spending will provide strong support for the U.S. economy through 2017 and 2018. Household net worth continues to rise and is well above average at this point in a long expansion (Chart 7). The total wealth effect for consumer spending is still lagging prior cycles, but remains supportive. Debt-to-income ratios are at multi-decade lows. The ongoing repair of consumer balance sheets has led to an all-time high in FICO scores (Chart 7, panel 4). Last week's U.S. flow of funds report also allows us to update BCA's Corporate Health Monitor (CHM) (Chart 8). The level of the CHM improved slightly between Q1 and Q2, but the overall level still suggests corporate balance sheets are deteriorating. The progress in Q2 was broadbased, as all the components improved, notably the net leverage component. Profit growth surged while debt moved up modestly in Q2, modestly reducing leverage. The Monitor has been a reliable indicator of the trend in corporate bond spreads. The upswing in the CHM in Q2 - and particularly the dip in leverage - supports our corporate bond overweight. On the consumer front, while the recent weakness in vehicle sales and overall retail sales are noteworthy, they do not signal the end of the business cycle. We found2 that a peak in vehicle sales leads the end of the economic cycle by two years. Moreover, Hurricane Harvey weighed on August's retail sales report and Irma will have the same impact on September's sales.3 Instead, the backdrop for consumer spending remains strong. For example, the most recent Fed Senior Loan Officer's Survey suggests that the banking sector is willing to lend to households and that consumers are open to borrowing, although household demand for loans has weakened in recent quarters (Chart 9). Chart 7Support For The Consumer##BR##Remains In Place Support For The Consumer Remains In Lace Support For The Consumer Remains In Lace Chart 8Improved A Bit In Q2##BR##But Still Deteriorating Improved A Bit In Q2 But Still Deteriorating Improved A Bit In Q2 But Still Deteriorating Chart 9Senior Loan Officers##BR##Survey Still Supportive Senior Loan Officers Survey Still Supportive Senior Loan Officers Survey Still Supportive In addition, consumer spending intentions remain in an uptrend and the decade-high readings on "plans to buy" a house and a car are telling (Chart 10, panels 1 and 2). Overall measures of consumer confidence remain at 16-year peaks (Chart 10, panel 3). Furthermore, the sturdy labor market, modest wage growth and low inflation are all factors that support a solid pace of real income growth, which reinforces the spending backdrop (Chart 10, panel 4). Student loan debt increased again in Q2 and investors are concerned by the risks posed by the upswing. The Bank Credit Analyst covered the topic in a comprehensive report in November 2016.4 The key message was that student debt is a modest drag on economic growth, but is not a threat to U.S. government finances and does not represent the next subprime crisis. Nearly a year later, BCA's conclusions remain unchanged. A recent report5 by the Federal Reserve Bank of New York provides data on student loans through Q2 2017. The report noted that while student debt levels were little changed between Q1 and Q2 2017, they are up $85B from a year ago and at record highs (Chart 11). Although student loan delinquencies ticked higher in Q2, and remain elevated by historical standards, they have moved sideways in recent years. We will continue to monitor all types of consumer indebtedness as we assess hazards in the U.S. economy. Student loans are only a mild economic headwind and do not represent a source of systemic financial risk. Chart 10Consumers Upbeat And Ready To Spend Consumers Upbeat And Ready To Spend Consumers Upbeat And Ready To Spend Chart 11Student Loan Debt Is Elevated Student Loan Debt Is Elevated Student Loan Debt Is Elevated Bottom Line: The consumer - a key driver of the U.S. economy and corporate earnings - will provide a solid backdrop for the economy through 2017 and beyond. This climate will allow the Fed to boost rates one more time this year and begin paring its balance sheet starting next month. The solid underpinnings for the consumer will sustain corporate earnings growth and, ultimately, higher stock prices. However, favorable consumer attitudes toward U.S. equity prices are a mild concern. Signals From Stock Sentiment Surveys Record U.S. consumer optimism - as measured by the University of Michigan (UM) - on forward stock returns does not necessarily signal a market top. On the other hand, it supports BCA's view that investors be prudent with risk allocations. Respondents to the UM Survey of Consumers assign a 65% probability that the U.S. stock market will move higher in the next 12 months, surpassing the previous zenith in mid-2004. Interestingly, before the 2014 high (60%), the top reading was in mid-2007 (62%), only three months prior to the October 2007 equity market peak. A cursory look at Chart 12, panel 1 shows that peaks on this metric line up with those in equities. We view it another way. Investors should not assume that stocks are peaking based on the UM data. The bottom panel of Chart 12 shows that at just 5.6%, the annual change in the percentage of respondents who expect stocks to move higher in the next 12 months is not at an extreme. The 12-month change was as high as 18% in early 2004 and again in March 2010. Stock returns in the 12 months after these peaks in sentiment were lower than in the 12 months prior. However, we are not yet in the danger zone based on this indicator. Furthermore, BCA's Investor Sentiment Composite Index (not shown) is not at an extreme, although it is at the top end of its bull market range. We expect the stock-to-bond ratio to move higher in the next 6-to-12 months, despite the elevated readings on households' expected return on stocks. Our position is driven more by our bearish stance on Treasury bond prices than on an overly bullish call on equity returns. Chart 13 illustrates this point across three time horizons given our view of fair value on the 10-year Treasury yield (2.67%).6 Our analysis assumes a 2% annualized dividend yield on the S&P 500. Panel 1 shows the ratio between now and year end will remain positive if U.S. equities dip by 5%. Looking ahead 6 and 12 months (Panels 2 and 3), the S&P 500 will have to drop by between 5% and 10% to signal a localized peak in the stock-to-bond ratio. Chart 12Consumers' Expectations For Equity Returns Are Elevated Consumers' Expectations For Equity Returns Are Elevated Consumers' Expectations For Equity Returns Are Elevated Chart 13Scenarios For Stock-To-Bond Ratio Scenarios For Stock-To-Bond Ratio Scenarios For Stock-To-Bond Ratio Bottom Line: Despite heightened consumer sentiment toward equities, we expect the stock-to-bond ratio to move higher in the next 6 to 12 months. Nonetheless, investors should be prudent with risk assets, paring back any maximum overweight positions and holding some safe-haven assets within diversified portfolios. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA's Global Fixed Income Strategy Weekly Report, "Have Bond Yields Peaked For The Cycle? No.", September 12, 2017. Available at gfis.bcaresearch.com. 2 Please see BCA's U.S. Investment Strategy Weekly Report, "Disconnected," September 11, 2017. Available at usis.bcaresearch.com. 3 Please see BCA's U.S. Investment Strategy Weekly Report, "Shelter From The Storm, "September 5, 2017. Available at usis.bcaresearch.com. 4 Please see The Bank Credit Analyst Special Report, "Student Loan Blues: Can't Replay What I Borrowed", November 2016. Available at bca.bcaresearch.com. 5 https://www.newyorkfed.org/medialibrary/interactives/householdcredit/data/pdf/HHDC_2017Q2.pdf 6 Please see BCA's U.S. Bond Strategy Portfolio Allocation Summary, "The Cyclical Sweet Spot Rolls On," September 5, 2017. Available at usbs.bcaresearch.com.

Highlights This week's FOMC statement telegraphed another rate hike in December and three more hikes in 2018. The ability of the Fed to deliver on these hikes will depend on whether inflation picks up. We think it will. Stronger GDP growth will push the unemployment rate below 4% next year, the threshold at which the Phillips curve becomes quite steep. The often-cited reasons for why the Phillips curve has become defunct - well-anchored inflation expectations, decreased union bargaining power, a more globalized economy, and technological trends - are less convincing than they appear. Underweight long-term government bonds and overweight equities for the next 12 months. Look to reduce risk exposure late next year. The beleaguered dollar could catch a bid over the coming months. We are closing our long Brent oil trade for a gain of 13.8%. Feature The Fed Delivers A "Hawkish Hold" Going into this week's FOMC meeting, there was some speculation among market participants that the Fed would signal a reluctance to raise rates in December and reduce the number of rate hikes planned for next year. In the end, that didn't happen. Twelve of the sixteen participants indicated that they expected the fed funds rate to rise in December, exactly the same number as in June. The Fed downplayed the effects of the hurricanes, noting that they would not "materially alter" medium-term growth prospects. The median number of rate hikes planned for next year also remained at three. The FOMC kept the long-term estimate of unemployment at 4.6%, despite trimming the forecast for end-2018 unemployment rate from 4.2% to 4.1%. The only substantive dovish changes to the dots came in the form of a cut in the number of hikes planned for 2019 from three to two, and a reduction in the terminal rate from 3% to 2.75%. Not surprisingly, the somewhat hawkish tone of the FOMC statement caused the implied odds of a December rate hike to jump from about one-in-two to two-in-three. The dollar also rallied, with the euro falling a full big figure against the greenback immediately following the release of the statement. Don't Write Off The Phillips Curve Just Yet Last week's higher-than-expected inflation print undoubtedly increased the Fed's willingness to keep raising rates. Nevertheless, despite the tentative rebound in inflation, core CPI inflation is down 0.6 percentage points since January on a year-over-year basis, while core PCE inflation is down 0.5 points over the same period. The failure of inflation to accelerate in response to diminished economic slack has convinced many people that the Fed will not be able to continue scaling back monetary stimulus. It has also prompted numerous commentators to pen obituaries for the so-called Phillips curve. Named after New Zealand economist William Phillips, the curve predicts that falling unemployment will lead to rising inflation. It is certainly true that the Phillips curve has become flatter over the past few decades (Chart 1). However, we think that it is premature to write it off as a useful tool for predicting inflation. This is because the Phillips curve tends to become much steeper once the economy reaches full employment. As we have discussed in the past, a variety of measures suggest that the U.S. is approaching this "kink" in the curve (Chart 2).1 Chart 1The Phillips Curve Has Gotten Flatter Is The Phillips Curve Dead Or Dormant? Is The Phillips Curve Dead Or Dormant? Chart 2U.S. Economy At Full Employment U.S. Economy At Full Employment U.S. Economy At Full Employment The idea that the Phillips curve steepens at low levels of unemployment is very intuitive: If excess capacity is high to begin with, a modest decline in slack will still leave many workers idle. In such a setting, inflation is unlikely to rise. However, once the output gap is fully closed, any further decline in slack will cause bottlenecks to emerge, pushing wages and prices higher. The empirical evidence supports this conclusion. Chart 3 shows that U.S. wage growth has tended to accelerate once the unemployment rate falls into the range of 4%-to-5%. Chart 3U.S. Wage Growth Accelerates Once The Unemployment Rate Falls To Low Levels Is The Phillips Curve Dead Or Dormant? Is The Phillips Curve Dead Or Dormant? The Absence Of Evidence Is Not Evidence Of Absence The past three U.S. business-cycle expansions never reached the stage where the economy had the chance to fully overheat. The 1982-90 cycle was cut short by the spiraling effects of the Savings & Loan crisis, while the 2001-2007 cycle was short-circuited by the housing bust. The closest the economy came to boiling over was during the 1990s expansion. However, that cycle was also prematurely terminated by the dotcom bust and the adverse knock-on effect this had on business investment spending. Moreover, the late 1990s expansion occurred against the backdrop of a soaring dollar, turmoil in emerging markets, and plummeting commodity prices. These external deflationary forces arguably overwhelmed the inflationary impulse stemming from an overheated domestic economy. The tendency of financial imbalances to metamorphize into full-blown recessions before inflation has had a chance to take off means that the U.S. has spent the past 30 years on the flat side of the Phillips curve. One can see this point analytically: Between 1964 and 1980, the unemployment rate was below the Fed's estimate of NAIRU 79% of the time, compared to only 29% of the time since 1980. It is thus no wonder that the Phillips curve looks dead - it has not been given a chance to come alive. This makes us sceptical of studies such as the recent one by the Philadelphia Fed which purported to show that the Phillips curve is no longer useful for forecasting inflation.2 The Kinky Sixties We argued several weeks ago that the next recession could resemble the "classic recessions" of the post-war era, which were caused by the Fed's decision to raise rates aggressively after realizing it was behind the curve in normalizing monetary policy.3 The 1960s provides a useful lesson in that regard. Just like today, inflation hovered below 2% during the first half of that decade, even though unemployment was trending downward over this period. To most observers back then, the Phillips curve would have also appeared defunct. However, once the unemployment rate fell below 4%, core inflation took off, rising from 1.5% in early 1966 to nearly 4% in 1967 (Chart 4). The kink in the Phillips curve had been reached. Inflation ultimately made its way to 6% in 1970, four years before the first oil shock struck. One might challenge the 1960s comparison on four grounds: First, inflation expectations are allegedly better anchored today; Second, trade unions play a much smaller role in the wage bargaining process; Third, globalization has purportedly made both product and labour markets much more competitive than they were back then, thus severely limiting the scope of firms to raise prices and wages; Fourth, the deflationary impact of new technologies such as robotics and online commerce has become more pervasive. We think all four of these explanations leave much to be desired. As far as inflation expectations are concerned, it is certainly true that central banks did not pursue explicit inflation targets during the 1960s. However, this does not mean that inflation expectations were necessarily poorly anchored. Ten-year Treasury yields averaged 4.1% in the first half of the sixties, well below the 6.6% pace of nominal GDP growth. Investors back then were clearly quite relaxed about inflation risk. This is not that surprising, given that the U.S. had not seen a period of sustained inflation since the Civil War. A decline in unionization rates is also often cited as a reason for why the Phillips curve may be flatter today. The problem with this argument is that it is very U.S.-centric. For example, while the U.S. has experienced a pronounced drop in unionization rates since the 1960s, Canada has not (Chart 5). Yet, the sensitivity of inflation to economic fluctuations has fallen in both countries by roughly the same magnitude. Likewise, the increased use of inflation-linked wage contracts in the 1970s appears mainly to have been a response to rising inflation rather than the cause of it (Chart 6). Chart 4Inflation In The 1960s Took Off Once The Unemployment Rate Fell Below 4% Inflation In The 1960s Took Off Once The Unemployment Rate Fell Below 4% Inflation In The 1960s Took Off Once The Unemployment Rate Fell Below 4% Chart 5Inflation Fell In Canada Despite A High Unionization Rate Inflation Fell In Canada Despite A High Unionization Rate Inflation Fell In Canada Despite A High Unionization Rate Chart 6Wage Indexation Was Mainly A Response To Rising Inflation Wage Indexation Was Mainly A Response To Rising Inflation Wage Indexation Was Mainly A Response To Rising Inflation Globalization And The Phillips Curve The extent to which globalization has flattened the Phillips curve remains the subject of intense debate. The empirical evidence is mixed, with most studies leaning towards the conclusion that globalization has had only a limited impact on the slope of the curve in large economies such as the U.S. This makes perfect sense, considering that the import share in U.S. personal consumption stands at less than 15%.4 Supporting this conclusion is the fact that wage growth appears to be just as sensitive to changes in the unemployment rate in industries that are highly exposed to trade as those which face little import competition. Upon deeper inspection, many of the arguments for why globalization has led to a flatter Phillips curve are really arguments for why globalization has limited the degree of movement along the Phillips curve. In a highly globalized world, a decline in slack in one country - unless matched by reduced slack in other countries - will lead to higher interest rates in that country and a stronger currency. A stronger currency, in turn, will choke off growth, preventing the unemployment rate from falling as much as it otherwise would. Clearly, such a sequence of events has not applied to the U.S. dollar since the start of the year. This suggests that the unemployment rate will either keep falling towards the steeper part of the Phillips curve, or the Fed will be forced to turn more hawkish. The Effects Of Technology What about the possibility that technological advances have led to a flatter Phillips curve? The problem here is that the data do not fit the story. As my colleague Mark McClellan has pointed out, almost all of the decline in inflation since the Great Recession has occurred in categories of the CPI - such as energy, food, and rent - that have little to do with e-commerce (Table 1).5 Also keep in mind that while online sales have grown rapidly during the past two decades, they still account for only 8.9% of total retail sales and less than 5% of the U.S. Consumer Price Index. Amazon's recent growth has actually lagged behind what Walmart experienced during its heyday (Chart 7). Table 1Comparison Of Pre- And Post-Lehman Inflation Rates Is The Phillips Curve Dead Or Dormant? Is The Phillips Curve Dead Or Dormant? Chart 7Amazon Vs. Walmart: Who's More Deflationary? Is The Phillips Curve Dead Or Dormant? Is The Phillips Curve Dead Or Dormant? The proliferation of big-box retailers pushed up productivity growth in the retail sector to 3.9% between 1992 and 2007. Productivity growth in this sector has fallen to 2.1% since then. This undercuts the notion that the explosion in e-commerce has produced major efficiency gains for the broader economy, thus contributing to deflationary pressures.6 Investment Conclusions U.S. inflation is likely to trend higher over the coming months as a variety of one-off factors that depressed inflation earlier this year fall out of the equation. The effects of the hurricanes complicate the picture, but history suggests that both inflation and growth tend to renormalize fairly quickly after such disasters. Hence, the markets will look through any near-term noise in the data, focusing instead on the cyclical growth outlook, which remains reasonably upbeat. Chart 8 shows that fluctuations in the ISM manufacturing index have often predicted changes in inflation. The current level of the ISM implies that core inflation will rebound to about 2% by the second half of next year. Risk assets are unlikely to suffer if inflation rises towards the Fed's target against the backdrop of stronger growth. However, if inflation moves above the Fed's target due to brewing supply bottlenecks, the Fed will have little choice but to pick up the pace of rate hikes. This could unsettle markets and sow the seeds for the next recession, which we tentatively expect to occur in the second half of 2019. What should investors do? Right now, none of our leading indicators are warning of an imminent economic downturn (Chart 9). Thus, we continue to recommend a cyclically overweight position in equities. However, we would not fault longer-term investors for starting to take money off the table, especially in light of today's lofty valuations. Chart 8ISM Has Often Predicted Changes In Inflation ISM Has Often Predicted Changes In Inflation ISM Has Often Predicted Changes In Inflation Chart 9No Warnings Of An Imminent Downturn No Warnings Of An Imminent Downturn No Warnings Of An Imminent Downturn The Fed is likely to raise rates in December and three or four more times in 2018. We are positioned for this by being short the December 2018 Fed funds futures contract, a trade that has gained 22 basis points so far. Considering that the market is pricing in only 42 basis points of hikes between now and the end of next year, there is plenty of juice left in this trade. A more aggressive-than-expected Fed could give the beleaguered dollar a much-needed lift. We see EUR/USD falling back to 1.15 by the end of the year and USD/JPY moving to 115. We are less bearish towards the British pound and the Swedish krona. Our short EUR/GBP and long SEK/CHF trades are up 2.6% and 5.4%, respectively, since we initiated them. Finally, we are closing our long December 2017 Brent oil futures contract for a gain of 13.8%. We still see modest upside for oil prices, and are expressing this view by being long the Canadian dollar and Russian ruble against the euro. Both currency trade recommendations remain in the money. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "A Secular Bottom In Inflation," dated July 28, 2017; and "What's the Matter With Wages?" dated August 11, 2017. 2 Michael Dotsey, Shigeru Fujita, and Tom Stark, "Do Phillips Curves Conditionally help To Forecast Inflation?"Federal Reserve Bank of Philadelphia, Working Paper no. 17-26 (August 2017). 3 Please see Global Investment Strategy Weekly Report, "From Slow Burn Recovery To Retro-Recession?" dated August 18, 2017. 4 Galina Hale and Bart Hobijn, "The U.S. Content of "Made in China"," FRBSF Economic Letter 2011-25 (August 8, 2011). 5 Please see The Bank Credit Analyst, "Did Amazon Kill The Phillips Curve?" dated August 31, 2017. 6 Ironically, if technological change has made the Phillips curve more flat, it may be because it has reduced competition rather than fostered it. The shift to a digital economy has allowed more companies to dominate their markets by virtue of network and scale effects. The expansion of such "winner-take-all markets" helps explain why industry concentration has risen over the past few decades, boosting profit margins in the process. A recent NBER working paper by Jan De Loecker and Jan Eeckhout found that the average U.S. publicly-listed firm set prices 67% above marginal costs in 2014 compared to 30% in 1990 and 18% in 1980. Economic theory suggests that firms with significant market power will tend to raise prices by less than highly competitive firms in response to costs increases. This would make the Phillips curve more flat. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights A major investment theme for the coming years will be the resynchronization of developed economy monetary policies. Expect substantial further convergence between U.S. T-bond yields and both German bund yields and Swedish bond yields. This yield convergence necessarily supports the currency crosses EUR/USD and SEK/USD. Underweight U.K. consumer services versus the FTSE100. Overweight German consumer services versus the DAX. The September 24 German election and October 1 proposed referendum on Catalan independence are not major catalysts for the financial markets. Feature A major investment theme for the coming years will be the resynchronization of developed economy monetary policies. As monetary policy resynchronizes, it will become clear that the extreme desynchronization of monetary policies over the past few years was the great anomaly (Chart of the Week and Chart I-2). This anomaly reached its peak in 2014 when policies at the ECB and the Federal Reserve moved in diametrically opposite directions. The ECB signalled the start of its quantitative easing just as the Fed began to end its own. Chart of the WeekThe Desynchronization Of Monetary##br## Policy Was An Anomaly The Desynchronization Of Monetary Policy Was An Anomaly The Desynchronization Of Monetary Policy Was An Anomaly Chart I-2The Desynchronization Of Monetary##br## Policy Was An Anomaly The Desynchronization Of Monetary Policy Was An Anomaly The Desynchronization Of Monetary Policy Was An Anomaly Why Did Monetary Policy Desynchronize? The extreme desynchronization of monetary policy would not have happened if it was just about economics. On the basis of the hard economic data, the ECB could have emulated the unconventional policies of the Fed, BoJ and BoE years before it eventually did in 2015. If it had, ECB policy would have been much more synchronized with the other major central banks. However, unconventional monetary policy wasn't, and isn't, just about economics. The ECB faced, and still faces, much tougher political and technical hurdles than other central banks. The euro area does not have one government, it has 19. The ECB had to convince sceptical core euro area governments that zero and negative interest rate policy and bond buying were not just a bailout for the periphery, especially with the euro debt crisis so fresh in the mind. Likewise, the euro area does not have one sovereign bond, it has 19. To design and implement an asset purchase program in the euro area is much more complicated than in the U.S., Japan or the U.K. But by mid-2014 it had become clear that each wave of unconventional monetary easing - through its impact on exchange rates - had allowed other major economies to 'steal' some inflation from the euro area (Chart I-3). With the ECB still undershooting its inflation mandate, it was becoming a dereliction of duty for the ECB not to do what the Fed, BoJ and BoE had already done several years earlier. As the saying goes, it is better for a reputation to fail conventionally, than to succeed unconventionally. Chart I-3Currency Depreciations "Steal" Inflation From Other Economies Currency Depreciations "Steal" Inflation From Other Economies Currency Depreciations "Steal" Inflation From Other Economies Why Will Monetary Policy Resynchronize? Three years and several trillion euros later, the ECB can feel it has had a fair crack at unconventional easing (Chart I-4). At the same time, the central bank must contend with fresh political and technical hurdles. How many more German bunds can it realistically buy without irking Germany's policymakers? Chart I-4The ECB Has Had A Fair Crack At QE The ECB Has Had A Fair Crack At QE The ECB Has Had A Fair Crack At QE The ECB is also aware that ultra-loose monetary policy - by compressing banks' net interest margins - endangers banks' fragile profitability. This impairs the bank credit channel which is the mainstay of private sector credit intermediation in the euro area.1 Meanwhile, the euro area's configuration of solid economic growth, solid job growth and subdued inflation is common to most large developed economies (the exception is the U.K. which we explain below). Putting all of this together, the theme for the coming years has to be monetary policy resynchronization, one way or the other. One way is that the more hawkish central banks will become less hawkish, as subdued inflation limits the scope for monetary policy tightening. The other way is that the more dovish central banks will become less dovish as the benefits of ultra-accommodation diminish and the costs rise. Or, both ways will happen together. Nowhere are negative bond yields more absurd and more inappropriate than in Sweden (Chart I-5). In just three years the economy has grown 12% and house prices have surged 50%. Furthermore, unlike in other parts of Europe, the housing market in Sweden did not suffer a meaningful setback in either 2008 or 2011. Yet Sweden's negative interest rate policy means that it stills pays people to borrow and further bid up house prices. If anywhere is at risk of a bubble from ultra-accommodative monetary policy, Sweden must be it. For bond yield spreads and currencies - which are relative trades - it doesn't really matter how the resynchronization of monetary policies occurs. We expect substantial further convergence between U.S. T-bond yields and both German bund yields and Swedish bond yields. And this yield convergence necessarily supports the currency crosses EUR/USD and SEK/USD (Chart I-6). Chart 5A Negative Bond Yield ##br##In Sweden Is Absurd A Negative Bond Yield In Sweden Is Absurd A Negative Bond Yield In Sweden Is Absurd Chart I-6If The Swedish Bond Yield Shortfall ##br##Compresses, The Krona Will Rally If The Swedish Bond Yield Shortfall Compresses, The Krona Will Rally If The Swedish Bond Yield Shortfall Compresses, The Krona Will Rally The Myth Of The Beneficial Currency Devaluation Sharp depreciations in a currency result in an economy 'stealing' inflation from its major trading partners. Chart I-7 and Chart I-8 suggest that absent the post Brexit vote slump in the pound, the gap between U.K. and euro area inflation would be almost 1% less than it is. Chart I-7The Weaker Pound Lifted ##br##U.K. Headline Inflation... The Weaker Pound Lifted U.K. Headline Inflation... The Weaker Pound Lifted U.K. Headline Inflation... Chart I-8...And U.K. ##br##Core Inflation ...And U.K. Core Inflation ...And U.K. Core Inflation So the Brexit vote explains why the U.K. is one of the few major economies where inflation is running well north of 2%. Unfortunately for U.K. households, nominal wage inflation has not followed price inflation higher. Which means that the pound's weakness has choked households' real incomes. Against this, textbook economic theory says that a currency devaluation should make a country's exports more competitive and thereby boost the net export contribution to economic growth. But in the textbook the only thing that is supposed to change is the exchange rate. The textbook assumes that the country's trading framework with its partners remains unchanged. In the case of the U.K. leaving the EU, this assumption clearly does not apply, mitigating the concept of the 'beneficial currency devaluation'. A lot of the benefits of the textbook devaluation come because firms can trade in markets that were previously unprofitable to them. This process requires investment - for example, in marketing and distribution. If Brexit means that many of those markets are no longer available, or come with tariffs, then firms will hold off making the necessary investments - unless the currency devaluation is massive. But in this case, the corresponding surge in inflation and choke on households' real incomes would also be massive. We also hear the myth of the beneficial currency devaluation applied to the weaker members of the euro area. As in, why don't these countries just break free from the euro, and devalue their way to prosperity? The simple answer is that if they left the euro, they would also risk losing access to the largest single market in the world - defeating the whole purpose of the beneficial currency devaluation! A Tale Of Two Consumers Chart I-9A Good Pair Trade: Long German Consumer ##br##Services, Short U.K. Consumer Services A Good Pair Trade: Long German Consumer Services, Short U.K. Consumer Services A Good Pair Trade: Long German Consumer Services, Short U.K. Consumer Services For the time being, hawkish comments from the BoE have given the pound a boost. But U.K. consumer spending now faces one of two headwinds. If the BoE follows through with a rate hike, household borrowing is likely to fade as a driver of spending. Alternatively, if the BoE backs off from its threat, the pound will once again weaken, push up inflation and weigh on real incomes. So for the time being, stay underweight U.K. consumer services versus the FTSE100. In Germany, the opposite logic applies. Stay overweight German consumer services versus the DAX. Euro strength helps German consumers in as much as it reduces the prices of imported food and energy. But for German exporters, the strong euro hurts the translation of their multi-currency international profits back into local currency terms. A good pair trade is to be long German consumer services, short U.K. consumer services (Chart I-9). Finally, regarding two upcoming political events - the September 24 German election and the October 1 proposed referendum on Catalan independence, we do not see either as a major catalyst for the financial markets. In the case of the German election, it is because no likely outcome is especially malign (or benign). In the case of the Catalan referendum, it is because it will be hard to draw any meaningful conclusion from the result, given that Madrid has ruled the referendum illegal - and many 'unionists' are unlikely to participate. Please note that there is no Weekly Report scheduled for next week as I will be at our New York Conference. I hope to see some of you there. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 In the euro area, small and medium sized companies tend to access credit through banks rather than through the bond market. Fractal Trading Model This week, we note an excessive underperformance of U.K. personal and household goods (dominated by BAT, Unilever, Reckitt Benckiser) versus U.K. food and beverages (dominated by Diageo and Associated British Foods). Go long U.K. personal and household goods versus U.K. food and beverages with a profit target / stop loss of 4.5%. In other trades, short nickel / long silver hit its 8% profit target, while short MSCI China / long MSCI EM hit its 2.5% stop loss. This leaves three open trades. 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-10 Long U.K. Personal and Household Goods / Short U.K. Food and Beverages Long U.K. Personal and Household Goods / Short U.K. Food and Beverages 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. * 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 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 Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

The Federal Reserve faces unprecedented turnover in its Board of Governors over the coming year. The recent resignation of Stanley Fischer occurred when three of the Board's positions were already vacant and there is the additional issue that Janet Yellen's term as Chair ends in January. It remains far from clear that she will be offered another term or would even choose to stay if given the chance.1 Even Governor Lael Brainard's position could change - her willingness to stay on at the Fed may depend on who is the next Chair and on the other Board appointments. The point is that President Trump has the opportunity to choose the people who will run the nation's monetary policy for years to come. The first Board appointment will be Randal Quarles, nominated to be vice-chair for supervision, a position created by the 2010 Dodd-Frank Act to oversee the banking industry. His nomination was recently cleared by the Senate Banking Committee and he should soon be accepted by the full Senate. Quarles has indicated that his position on financial regulations is much softer than that of Yellen. Not surprisingly, there are widespread concerns about the looming changes to the Fed's Board. There are fears that new appointments may lack appropriate expertise and/or that they will have an intellectual bias that could result in overly tight or overly easy policies. Most Fed Chairmen have been highly-regarded economists with extensive experience in policymaking. One notable exception was G. William Miller, who served as Fed Chair from March 1978 until August 1979. Mr. Miller, appointed by President Jimmy Carter, came from a business background - he was CEO of the conglomerate Textron Inc. His short tenure at the Fed was regarded as a failure because he did not take tough action to deal with a growing inflation problem. That challenge was left to his successor, Paul Volcker. Many names have been touted as possible successors to Janet Yellen, including former Fed Governors Kevin Warsh and Larry Lindsey, Professors John Taylor and Glen Hubbard, and former bank CEOs Richard Davis and John Allison. Media reports suggest that the previous front-runner, Gary Cohn, is out of consideration following his criticism of President Trump's response to the Charlottesville clash between right-wing extremists and their objectors. How much will it matter to the economy and markets which person is chosen? The Fed's Scorecard Monetary policy is important because its sets the short-term price of a very important commodity - money! If the price is set too low, then financial excesses are virtually inevitable and if the price is set too high then economic activity is choked off. Yet knowing exactly where to set that price is no simple matter. The appropriate level of short-term interest rates is not observable and is a function of many variables, including the amount of slack in the economy, inflationary pressures, the level of financial conditions, and international factors. The Fed uses different economic models to help its decision making, but these have proved to be of dubious value. As we highlighted in an earlier report this year, the Fed has failed to forecast every recession during the past 60 years (Table 1).2 Yes, the Fed has been successful in achieving low and relatively stable inflation, but only after major policy errors during the 1960s and 1970s allowed inflation to spiral out of control. Table 1Fed Economic Forecasts Versus Outcomes Should You Fear Looming Changes At The Federal Reserve? Should You Fear Looming Changes At The Federal Reserve? The Fed's Open Market Committee (FOMC) is not run as a dictatorship, yet the person at the helm does have real power. Weak leadership was partly responsible for the inflationary policy errors of the 1960s and 1970s and the strong hand of Paul Volcker was important in launching the attack on inflation in the 1980s. The aura of invincibility surrounding Alan Greenspan during the second half of his tenure as Fed Chair cowed opposition from other FOMC members and contributed to the major error of weak regulatory oversight during a massive buildup of financial imbalances in the 2000s. Central bankers have long believed that price stability is a key prerequisite for maximizing an economy's potential. If we judge the effectiveness of post-WWII Fed leaders solely by the performance of inflation during their tenure, then Chart 1 shows we must give failing grades to those in charge during the 1950s, 60s and 70s - William McChesney Martin (1951-1970), Arthur Burns (1970-78) and G. William Miller (1978-79). Subsequent Chairs get passing grades - Paul Volcker (1979-87), Alan Greenspan (1987-06), Ben Bernanke (2006-2014) and Janet Yellen (2014-). However, it is not quite as simple as that. The Fed has a dual mandate - the Federal Reserve Act requires that policy achieves maximum employment as well as stable prices. And the Fed also plays an important regulatory role in maintaining financial stability. Chart 1The Fed's Record With Its Dual Mandate The Fed's Record With Its Dual Mandate The Fed's Record With Its Dual Mandate If we also take account of trends in the labor market and financial stability, the performance of Fed Chairs alters a bit. The second panel of Chart 1 shows the difference between the unemployment rate and its full employment level (based on estimates by the Congressional Budget Office). The Chairs who presided over rising inflation also managed to keep unemployment low for most of the time. And the cost of Volcker's attack on inflation was a deep recession and spike in unemployment. On average, Greenspan's record on growth and thus unemployment was good, but as we noted, he allowed an unprecedented buildup of financial excesses. This helped to create the conditions for the deepest economic and financial downturn since the 1930s but it was his successor, Ben Bernanke, who had to deal with that problem. Another way to assess the Fed's record is to compare the actual funds rate to the level implied by the Taylor Rule. Professor John Taylor's rule calculates the appropriate funds rate based on the deviation of inflation from 2% and the gap between real GDP and its full employment level. The starting point is the assumption that the real equilibrium rate is 2%. If, for example, inflation was above target and the economy was operating above potential, then the rule would require a real funds rate above 2%. There is a widely-accepted view that the real equilibrium rate declined after the 2007-09 downturn so, in our calculations, we use a level of 0.5% after 2007.3 Chart 2 shows that rising inflation of the 1950s, 60s and 70s coincided with the funds rate being kept below the level implied by the Taylor Rule estimate. Not surprisingly, Volcker had to push the funds rate far above normal to start the disinflation process. Subsequently, both Greenspan and Bernanke kept the funds rate relatively close to the Taylor-implied level. Yellen has kept the rate below our estimate and Taylor has been a critic of the Fed's easy money policies. However, some studies suggest that the real equilibrium rate may be even lower than the 0.5% we have assumed. Chart 2The Fed Funds Rate: Actual Versus The Taylor Rule The Fed Funds Rate: Actual Versus The Taylor Rule The Fed Funds Rate: Actual Versus The Taylor Rule Which Fed Chair was best for investors? Chart 3 shows real return indexes for bonds and equities. Not surprisingly, bond returns performed poorly during the periods of rising inflation and Volcker's reign coincided with the start of a long-term bull market. The equity market rose strongly under Martin, helped by a healthy economy, but in terms of annualized returns during the various Chairs, Volcker takes first place. The real returns for both markets are summarized in Table 2. Although the market did well under Greenspan, the severe bear market of 2000-02 occurred under his watch and, as previously noted, his regulatory lapses set the scene for the 2007-09 market debacle. Yellen had the second-best returns among the Fed Chairs listed for both bonds and stocks, highlighting the power of zero interest rates and quantitative easing! Chart 3The Fed And Market Returns The Fed And Market Returns The Fed And Market Returns Table 2Fed Chairs And Market Returns Should You Fear Looming Changes At The Federal Reserve? Should You Fear Looming Changes At The Federal Reserve? So What? The errors made by policymakers to some extent reflect the biases created during their formative years. For example, for those in charge during the 1950s and 60s, fears of renewed depression probably outweighed those of inflation. And the experience of runaway inflation in the 1970s cemented a powerful anti-inflation bias in those central bankers who gained experience during that time. Volcker was in the Fed before inflation took root, but one could argue that whoever had taken over from William Miller would have been forced to take tough action. Inflation was such a severe problem that no Fed Chair could have allowed it to continue. While Volcker deserves a lot of praise, it should be noted that inflation declined in virtually all industrial countries during the 1980s and beyond, even in cases where central banks had not yet achieved independence. The U.S. was in the vanguard of fighting inflation, but the trend in inflation rates was broadly the same in the U.S. and in the median of 18 other industrial countries (Chart 4). Chart 4The Fed Was Not Unique In Driving Down Inflation The Fed Was Not Unique In Driving Down Inflation The Fed Was Not Unique In Driving Down Inflation At the swearing-in ceremony for Fed Chair Arthur Burns, President Richard Nixon reportedly said "I respect his independence. However, I hope that independently he will conclude that my views are the ones that should be followed". Burns did indeed take an overly soft line on inflation. It is widely assumed that President Trump would prefer someone who will maintain a low interest rate policy in order to support economic growth. It would be a particular concern if the U.S. Administration were to fill the Fed Board with people who had little or no economic and/or policy experience. With the looming departure of Stanley Fischer, there already is a worrying dearth of policy expertise and institutional memory on the Board. President Trump has shown a predilection to favor successful businesspeople for senior cabinet posts and the William Miller's record is not encouraging in that regard. However, it is doubtful that the Senate would approve a full slate of new Board members that is completely devoid of appropriate experience. Moreover, some of the people being touted as possible successors to Yellen, most notably John Taylor, Kevin Warsh and Glenn Hubbard are respected economists who would not be political puppets in pursued of irresponsible policies. If Quarles joins the Fed Board he will push for an easing in bank regulations and will likely get the support from the Chair if a former bank CEO replaces Yellen. However, there would be severe pushback from the staff and other Governors. With memories of the 2007-09 downturn still relatively fresh, Congress also may be wary of a major rollback of regulations. Some Dodd-Frank regulations may be eased - especially for community banks - but we do not anticipate a return to a systemically-dangerous lax regime. What about the Fed's vulnerability to attempted interference from the Administration? Even if President Trump managed to install a new Chair that he deemed loyal and who shared his policy visions, this person would face challenges. The Fed staff is powerful and would make strong arguments against policies they believed to be inappropriate. Importantly, the policymaking process is a lot more transparent now than in the days when Fed Chairs Burns and Miller bowed to political influence. The publication of Fed economic forecasts and detailed meeting minutes would quickly highlight internal policy disagreements and financial market pressures would come into play. And while the Administration gets to nominate people to the Fed's Board, it is not able to remove them. A bigger concern is the possibility that Congress could pass legislation to audit the Fed, including its policy decisions. Earlier this year, the House Committee on Oversight and Government Reform approved the Federal Reserve Transparency Act of 2017, a bill sponsored by Rand Paul, a frequent Fed critic. The bill "directs the Government Accountability Office (GAO) to complete, within 12 months, an audit of the Federal Reserve Board and Federal Reserve banks. In addition, the bill allows the GAO to audit the Federal Reserve Board and Federal Reserve banks with respect to: (1) international financial transactions; (2) deliberations, decisions, or actions on monetary policy matters; (3) transactions made under the direction of the Federal Open Market Committee; and (4) discussions or communications among Federal Reserve officers, board members, and employees regarding any of these matters." Attempts to pass similar legislation in the past have failed, but President Trump is apparently in favor, as are many in Congress. The Fed Chair already faces twice-yearly interrogations by the House and Senate Banking Committees and that has not impacted policy decisions. Nevertheless, any politicization of Fed decisions would be a problem. At the moment, detailed transcripts of Fed meetings are released with a five-year time lag. Publication of internal Fed deliberations within a year of the bill's passage could compromise the willingness of FOMC participants to take unpopular decisions. The Policy Outlook The reality is that Fed policy will largely be constrained by economic environment, regardless of who is the Chair. A lackluster economic expansion and softer-than-expected wage growth and inflation have supported the maintenance of accommodative policies. But, in the absence of a new downturn, the Fed will stick to its plan of winding down its balance sheet and slowly raising interest rates. If anything, market expectations of a fed funds rate of only 1.5% by the end of 2018 seem too low. Dollar weakness and a strong stock market have meant an easing in overall financial conditions and the fiscal environment is set to become more stimulative. Whoever is leading the Fed next year will be under pressure to communicate a more hawkish stance to the markets. The long-run outlook for monetary policy is a more open question. There will be another recession - possibly as soon as 2019 - and that could be quite a deflationary affair. The next generation of central bankers will have spent more of their formative policy years in an environment when inflation was not a major economic problem and they will have come to terms with the extreme monetary actions needed during the 2007-09 collapse. And with massive quantitative easing failing to deliver the high inflation that many feared, any barriers to even more desperate measures may be limited. Thus, the next downturn may sow the seeds of a return to much higher inflation. Given that demographic trends and a political failure to reign in entitlements will lead to rapidly growing public sector debt, higher inflation would be welcomed by the political establishment. The bottom line is that looming changes in the composition of the Fed's Board of Governors is important, but we doubt that the overall integrity of the Fed will be seriously compromised by bad appointments. However, at this stage, it is futile to guess who the Administration will choose. Regardless of who controls the Fed, there always will be the potential for errors because their economic models (along with everybody else's) are imprecise, data can be unreliable, and the policy tools are crude. Some uptick in inflation is likely and would even be desirable, but it will not be allowed to get out of control. The bigger uncertainty is what will happen after the next economic downturn because even the most hawkish policymakers may be forced to embrace inflationary policies that will make the past cycle's actions pale by comparison. Martin H. Barnes, Senior Vice President Economic Advisor mbarnes@bcaresearch.com 1 Yellen's renomination chances may have been undermined by her recent Jackson Hole speech defending the current financial regulatory regime because that puts her at odds with the Administration's desire to unwind some of the Dodd-Frank rules. 2 This table was originally shown in our Special Report "Beware the 2019 Trump Recession", March 7, 2017. 3 There are several variants of the Taylor Rule, depending on smoothing co-efficients and the choice of the real equilibrium rate. We base our estimates on the formula used by the Federal Reserve Bank of Atlanta, with the one change of lowering the real equilibrium rate to 0.5% after 2007. The FRB Atlanta data can be accessed at https://www.frbatlanta.org/cqer/research/taylor-rule.aspx

Highlights Duration: The bond market is quick to react to any signs that inflation might put in a bottom, but Treasuries are still not priced for a resumption of inflation's modest cyclical uptrend. Remain at below-benchmark duration and short the July 2018 fed funds futures contract. Fed Balance Sheet: The Fed will announce the run-off of its balance sheet at tomorrow's FOMC meeting. This decision has implications for Treasury issuance and how monetary policy will be conducted in the future, but we do not envision a large impact on yields. Investors should remain focussed on changes in the expected path of the fed funds rate to assess the outlook for Treasury yields. Feature Yields bounced back strongly last week, driven by a combination of easing flight-to-safety flows and a reasonably strong August CPI report. Even so, the bond market remains priced for an environment where inflation will never return to the Fed's 2% target, no matter the pace of economic growth. It should therefore not be shocking that yields are quick to spring higher on any evidence that core inflation might re-gain its cyclical uptrend (Chart 1). As we have previously written,1 we anticipate that core inflation will soon respond to above-trend growth and resume its modest cyclical uptrend. It is therefore worth considering whether last week's August CPI report represents a step in that direction or whether it should be written off as an outlier. After digging into the report's details we conclude that while it was probably stronger than we should expect going forward, it also suggests that core inflation is poised to put in a bottom. A Bottom In Core Inflation? Month-over-month core CPI increased 0.248% in August, an annualized pace of 3.02%, and the annualized 3-month rate of change rose back above the 12-month growth rate (Chart 2). This often signals a near-term trend reversal. Chart 1Very Sensitive To Inflation Very Sensitive To Inflation Very Sensitive To Inflation Chart 2Core Inflation By Major Component Core Inflation By Major Component Core Inflation By Major Component Shelter inflation jumped higher in August from 3.18% year-over-year to 3.30%. But our model suggests that this uptrend will not persist (Chart 2, panel 2). Notably, the increase in shelter inflation was concentrated in the Houston/Galveston/Brazoria area and as such reflects the one-off impact of Hurricane Harvey. The bottom line is that the positive August number should be considered an outlier. The underlying trend remains one of decelerating shelter inflation. Chart 3Ignore CPI Medical Care Ignore CPI Medical Care Ignore CPI Medical Care In contrast, year-over-year core goods prices decelerated in August, but this deceleration is equally unsustainable. The recent depreciation of the U.S. dollar and surge in non-oil import prices suggest that core goods inflation is poised to increase (Chart 2, panel 3). We expect accelerating core goods prices to offset decelerating shelter prices during the next few months. In the longer-run, neither shelter nor core goods will be sustainable drivers of inflation. Shelter has already rolled over, and core goods inflation will do the same once the dollar reverses its downtrend. For overall core inflation to sustainably return to the Fed's 2% target, core services inflation (excluding shelter and medical care) must be the main source of price pressure. Historically, this component of inflation is the most tightly linked to wage growth (Chart 2, bottom panel), and it has fallen precipitously so far this year. In August, however, year-over-year core services inflation (excluding shelter and medical care) ticked higher from 1.18% to 1.40%. While this is a positive sign, we will need to see further strength in this component to be certain that the downtrend in core inflation has turned. Some pundits have pointed to the steep decline in medical care CPI inflation as an additional deflationary force, but this is a red herring (Chart 3). In the CPI basket, medical care includes only consumers' out of pocket healthcare expenses. It does not include spending by the government on households' behalf, which is included in the Fed's target PCE inflation measure. Unlike CPI medical care, PCE medical care inflation has seen only a mild downturn and should move higher in August based on the most recent PPI numbers (Chart 3, panel 3). The bottom line is that the downtrend in CPI medical care inflation represents nothing more than a convergence between CPI and PCE inflation. Since the Fed targets PCE inflation, falling CPI medical care inflation can be safely ignored. The Fed's Reaction The Fed has already sent a strong signal that there will be no rate hike at this week's meeting, but that it will announce the run-off of its balance sheet (see next section). Our view has been that if inflation shows some signs of rebounding, the Fed will deliver another rate hike in December. The market appears to have taken a similar view and, on the strength of last week's CPI report, is now discounting a 51% chance of another rate hike this year. Last week's CPI report was probably strong enough to ensure that the median FOMC forecast will still call for one more hike this year when the revised forecasts are released tomorrow. However, we suspect that stronger inflation will need to persist for the next few months in order for that hike to be delivered on time. The reading from our Fed Monitor2 underscores how close a call another rate hike is at the moment (Chart 4). The monitor remains in "tighter money required" territory, but only faintly so. Notably, the economic growth and financial conditions components of the monitor both suggest that higher rates are required, but the inflation component remains below zero. This supports the notion that any sign of stronger inflation makes the case for further rate hikes a slam dunk. Chart 4A Close Call For The Fed A Close Call For The Fed A Close Call For The Fed Bottom Line: The bond market is quick to react to any signs that inflation might put in a bottom, but Treasuries are still not priced for a resumption of inflation's modest cyclical uptrend. Remain at below-benchmark duration and short the July 2018 fed funds futures contract. Five Questions About The Fed's Balance Sheet As was mentioned above, the Fed appears set to announce that it will cease the reinvestment of its bond holdings, meaning that its balance sheet will finally start to shrink. In all likelihood this announcement will come in tomorrow's FOMC statement. To recap, here is what we already know about how the plan will proceed: The Fed will cease the reinvestment of Treasuries and MBS at the same time. For the first three months the Fed will allow a maximum of $6 billion in Treasuries and $4 billion in MBS to run off each month. These caps will increase in steps of $6 billion and $4 billion, respectively, every three months until they level off at $30 billion per month for Treasuries and $20 billion per month for MBS. Question 1: How Long Will It Take? To answer this question we must first recall that the Fed does not target a specific level of assets on its balance sheet. Rather, it is the amount of bank reserves in the system (a liability on the Fed's balance sheet) that is the crucial variable for the economy. Bank reserves are the single biggest liability on the Fed's balance sheet, but the amount of currency in circulation is the second biggest. As of last Wednesday, bank reserves totaled $2.4 trillion and currency in circulation totaled $1.6 trillion. The amount of currency in circulation also increases as the economy grows. This means that during normal times the Fed must increase its asset holdings in line with the amount of outstanding currency just to keep the level of bank reserves constant. In other words, even if the Fed allows bank reserves to fall all the way to zero, it will still carry a larger balance sheet than it did prior to the start of QE because of the rising amount of currency in circulation. We have received no official guidance on the level of bank reserves the Fed will target for the end of the run-off process. However, New York Fed President William Dudley recently recommended that this level should be higher than during the pre-QE period. Together, as a rough starting point, we have suggested that the necessary amount of excess reserves could be in a range of $400 billion to $1 trillion. Coupled with uncertainty about the likely growth in other factors, such as currency outstanding, this implies a normalized balance sheet size of, perhaps, $2.4 trillion to $3.5 trillion in the early 2020s.3 In our estimates we have assumed that bank reserves will level-off once they reach $650 billion, considerably above levels maintained prior to the financial crisis. Bank reserves averaged $20 billion between 2000 and 2007. There are two main reasons why the Fed will favor a higher level of reserves. The first was also stated in President Dudley's speech: Having managed the System Open Market Account during the financial crisis - a period during which the demand for reserves was very volatile - I very much favor a floor-type system. It is much easier to manage on a day-to-day basis. A "floor system" means that the Fed controls the overnight rate by paying interest on excess reserves and conducting reverse repos with the securities on its balance sheet. This is the system currently in use, and it requires a glut of reserves in the banking system. Prior to the financial crisis, the Fed used a "corridor system" to control interest rates. This system required the Fed to transact in the interbank market to manage interest rates, and it required a dearth of reserves.4 The second reason is that the demand for safe short-maturity investment vehicles has been steadily increasing for at least the past fifteen years, largely due to rising cash balances on corporate balance sheets. Prior to the financial crisis this demand was intermediated through the repo market, but now that repo has mostly gone away, that cash is sitting on deposit at the Fed in the form of reserves (Chart 5). With all this demand, if the Fed tries to remove too many reserves from the banking system it could have difficulty keeping a floor under interest rates. That is, unless some other investment vehicle is supplied to mop up the rising demand for safety. In this regard, T-bills would be the most likely candidate, and fortunately, with T-bills at multi-decade lows as a percentage of the outstanding funding mix (Chart 6), there is ample room for the Treasury to increase bill supply. In short, the secular uptrend in demand for safe short-maturity financial assets means that going forward either: (i) the Fed will have to maintain a greater level of reserves in the banking system, (ii) the Treasury will have to increase the supply of T-bills, or (iii) some combination of the two. With all that in mind, let's answer the initial question of how long the Fed will allow its balance sheet to shrink. Our projections are shown in Chart 7, and make the following assumptions: Chart 5Rising Demand For Safe Short-Dated Assets Rising Demand For Safe Short-Dated Assets Rising Demand For Safe Short-Dated Assets Chart 6T-Bill Issuance Has Room To Rise T-Bill Issuance Has Room To Rise T-Bill Issuance Has Room To Rise Chart 7Fed Balance Sheet Projections Fed Balance Sheet Projections Fed Balance Sheet Projections Balance sheet run-off begins October 1, 2017 Bank reserves level-off at $650 billion. At that point, the Fed will continue to allow MBS to run off its balance sheet, but will start buying Treasuries to keep reserves stable. MBS will run off at a pace of $15 billion per month, before considering the caps.5 Currency in circulation will grow at a pace of 4.5% per year. Under these assumptions, we estimate that bank reserves will reach the target level of $650 billion in June 2021. At that point, the Fed's securities holdings will total $2.9 trillion - down from the current $4.3 trillion - and the Fed will have to start buying Treasuries to keep reserves stable and compensate for the continued run-off of MBS. Question 2: What Does This Mean For Bond Supply? To compensate for balance sheet run-off, The Treasury will have to increase issuance by $217 billion in 2018, $249 billion in 2019 and $182 billion in 2020 (Chart 8). Then, in 2021 and beyond, the Fed will once again start removing Treasury supply from the market as it stabilizes reserve balances. We estimate that an extra $150 billion of MBS supply will also hit the market in 2018, but we will save a discussion of the impact on MBS spreads for a future report. Chart 8Fed Starts Buying Again In 2021 Fed Starts Buying Again In 2021 Fed Starts Buying Again In 2021 The form in which this extra issuance will reach the marketplace is a question for the Treasury department. Officially, the Treasury has said: Treasury will likely respond to the additional borrowing needs associated with SOMA redemptions by increasing both Treasury bill and Treasury nominal coupon auction sizes, beginning with bills and then coupons, as appropriate.6 But the Treasury Borrowing Advisory Committee has recommended both that the Treasury increase the proportion of T-bills in its funding mix and increase the size of future coupon auctions, starting as early as next quarter. We expect these recommendations will be heeded. Question 3: Who Will Buy All These Bonds? A full breakdown of Treasury demand from different financial market actors is beyond the scope of this report. However, there is one sector that will need to greatly increase its holdings of Treasury securities as reserves are drained. That is the banking sector. The relatively new Liquidity Coverage Ratio (LCR) mandates that banks hold high-quality liquid assets (HQLA) in an amount sufficient to cover net cash outflows during a stressed 30-day period. HQLAs consist of Level 1 assets and Level 2 assets. Level 1 assets are bank reserves and Treasury securities, Level 2 assets are other riskier securities such as Agency MBS. A haircut is applied to level 2 assets for the purposes of calculating HQLA. Based on disclosures from the eight U.S. Systemically Important Financial Institutions (SIFIs), we calculate that HQLAs total about $2.4 trillion from those 8 banks alone (Table 1). If we assume that required HQLAs increase at a pace of about 4% per year (in line with expected growth in deposits), then that represents close to $100 billion of baseline Treasury demand next year and in 2019. This demand will also have to increase to compensate for the draining of reserves from the system (Chart 9). Table 1Liquidity Coverage Ratios For The 8 U.S. SIFIs The Great Unwind The Great Unwind Chart 9Bank Balance Sheets Loaded With Reserves Bank Balance Sheets Loaded With Reserves Bank Balance Sheets Loaded With Reserves At least at present, the eight largest U.S. banks do not have much of a buffer above the 100% mandated LCR. This means they will have to be active buyers of securities in order to compensate for lost reserves and keep their ratios stable. Question 4: What Will Be The Market Impact? It has been our long-standing view that the bulk of the impact on Treasury yields from Federal Reserve asset purchases can be attributed to signaling about the future path of short rates. In fact, throughout the entire QE period, there remained a strong positive correlation between long-maturity real Treasury yields and the number of rate hikes expected during the next 24 months (Chart 10). Chart 10Real Yields Driven By Rate Expectations Real Yields Driven By Rate Expectations Real Yields Driven By Rate Expectations Even theoretically, as Michael Woodford explained in his seminal Jackson Hole address from 2012,7 there is little reason to expect that central bank asset purchases exert an impact on bond yields beyond signaling about the future path of interest rates: In the representative-household theory, the market price of any asset should be determined by the present value of the random returns to which it is a claim, [...]. Insofar as a mere re-shuffling of assets between the central bank and the private sector should not change the real quantity of resources available for consumption in each state of the world, [...] the market price of one unit of a given asset should not change [...]. A more thorough empirical examination also suggests that the "signaling channel" explains most of the reaction in long-maturity Treasury yields to announcements about Fed asset purchases. We looked at a sample of dates where the Fed either made or teased an announcement related to its asset purchases, and then looked at how different financial markets reacted to those announcements. Chart 11 shows changes in the 10-year Treasury yield on the days in our sample versus changes in our 24-month fed funds discounter - the expected number of rate hikes during the next 24 months as discounted in the overnight index swap (OIS) curve. The chart shows a very strong linear relationship between changes in the 10-year Treasury yield and in expected rate hikes on those days. Chart 1110-Year Treasury Yield Vs. 24-Month Fed Funds Disc The Great Unwind The Great Unwind Chart 12 uses the same sample of dates, but this time looks at the change in the 10-year Treasury yield versus the change in the 10-year OIS rate. The pay-off on overnight index swaps is directly tied to the level of the fed funds rate. Therefore, if Fed asset purchases exert some impact on Treasuries above and beyond sending a signal about the future path of the fed funds rate, we should expect that impact to show up in Treasury yields but not in OIS rates. However, Chart 12 shows that changes in the 10-year Treasury yield and in the 10-year OIS rate remained tightly linked throughout our sample. Chart 1210-Year Treasury Yield Vs. 10-Year OIS Rate* Following Announcements Related##br## To Federal Reserve Asset Purchases The Great Unwind The Great Unwind Why is it important that the impact of Fed asset purchases on Treasury yields was mostly about signaling? It is because the Fed is following a "subordination strategy" with respect to the wind-down of its balance sheet. It plans to provide us with the schedule of balance sheet run-off in advance, and then leave that schedule un-touched regardless of economic developments. Put differently, it will respond to deteriorating economic conditions by cutting the fed funds rate before it alters the pace of balance sheet run off. In essence, the link between the Fed's balance sheet and signals about the path of the fed funds rate has been severed. As long as the "subordination strategy" is strictly enforced, we should not expect much of an impact on long-maturity Treasury yields from the unwinding of the Fed's balance sheet. Question 5: Are There Any Other Potential Market Impacts? Where Fed asset purchases essentially removed Treasuries (and MBS) from the market and replaced them with bank reserves (cash), the running down of the Fed's balance sheet will reverse this swap. Supplying securities into the market and removing cash. Some have argued that this removal of cash could lead to an appreciation of the U.S. dollar. In particular, Zoltan Pozsar of Credit Suisse has observed a correlation between U.S. bank reserves and FX basis swap spreads.8 There is also a strong correlation between FX swap spreads and the U.S. dollar (Chart 13). Chart 13Basis Swaps, Reserves And The Dollar Basis Swaps, Reserves And The Dollar Basis Swaps, Reserves And The Dollar One possible chain of events is that as the Fed drains cash from the market, there will be less liquidity in the FX swap market. Basis swap spreads will widen as a result, and this will cause the dollar to appreciate. In this framework, the unwinding of the Fed's balance sheet will put upward pressure on the U.S. dollar. However, it is also possible that the chain of causation runs in the other direction. The BIS has proposed a model9 where a stronger dollar weakens the capital positions of bank balance sheets. This causes them to back away from providing liquidity to the FX swap market, leading to wider basis swap spreads. In this model, a strong dollar leads to wider basis swap spreads and not the reverse. If this is the correct direction of causation, then we should not expect any impact on the dollar from the unwinding of the Fed's balance sheet. At the moment it is impossible to tell which of the above two theories are correct. All we can do is monitor the correlation between reserves, FX basis swap spreads and the dollar going forward. Bottom Line: The Fed will announce the run-off of its balance sheet at tomorrow's FOMC meeting. This decision has implications for Treasury issuance and how monetary policy will be conducted in the future, but we do not envision a large impact on yields. Investors should remain focussed on changes in the expected path of the fed funds rate to assess the outlook for Treasury yields. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Open Mouth Operations", dated September 2, 2017, available at usbs.bcaresearch.com 2 For further details on the monitor please see U.S. Bond Strategy Weekly Report, "Buy The Back-Up In Junk Spreads", dated March 14, 017, available at usbs.bcaresearch.com 3 https://www.newyorkfed.org/newsevents/speeches/2017/dud170907 4 For a detailed description of the differences between a floor and corridor system please see U.S. Bond Strategy / Global Fixed Income Strategy Special Report, "The Way Forward For The Fed's Balance Sheet", dated February 28, 2017, available at usbs.bcaresearch.com 5 For simplicity we assume a constant pace of $1 billion MBS refinancing every month. This is somewhat below recent averages to account for the likelihood that interest rates will rise. 6 https://www.treasury.gov/press-center/press-releases/Pages/current_PolicyPressRelease.aspx 7 http://www.columbia.edu/~mw2230/JHole2012final.pdf 8 https://ftalphaville.ft.com/2017/04/13/2187317/where-would-you-prefer-your-balance-sheet-banks-or-the-federal-reserve/ 9 http://www.bis.org/publ/work592.pdf Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Fed vs. BoE: U.S. inflation data is stabilizing, while financial conditions continue to ease. The market is underestimating the potential for the Fed to hike rates again, perhaps as soon as December. At the same time, markets have priced in too many rate hikes in the U.K., with the Bank of England's growth and inflation forecasts unlikely to be realized. USTs vs. Gilts: Maintain an overall below-benchmark portfolio duration tilt, while keeping an underweight stance on U.S. Treasuries and a neutral bias towards Gilts. Look to upgrade Gilts on any additional spread widening versus Treasuries or core Europe. Duration Checklists: An update of our Duration Checklists shows that the backdrop for growth, inflation and investor risk appetite remains bearish for U.S. Treasuries and German Bunds. Maintain below-benchmark duration exposure to both markets on a medium-term basis. Feature Inflation: Waking Up In The U.S., Peaking Out In The U.K. The bull market in risk assets remains powerful. Investors have shrugged off the worries about U.S. hurricanes and geopolitical tensions and have returned to focusing on the global growth and inflation backdrop. The fact that the S&P 500 could close at a new all-time high just above 2500 last Friday, shortly after another North Korean missile launch and a terrorist attack on the London Underground, speaks volumes about the renewed confidence (or is it hubris?) of investors. For bond markets, two events stood out - the firming read on August U.S. CPI inflation data and the surprisingly hawkish commentary from the Bank of England (BoE). We advise that investors pay more attention to the former and fade the latter. The U.S. inflation data is far more important, as it showed a decent rise in core inflation after five months of very weak prints (Chart of the Week). Chart of the WeekUSTs At Risk From A Rebound In Inflation USTs At Risk From A Rebound In Inflation USTs At Risk From A Rebound In Inflation A rebound in inflation is critical to our call for U.S. bond yields to rise over the next 6-12 months, as it would bring Fed rate hikes back into play. Right now, there is still a significant gap between market expectations for the fed funds rate by the end of 2018 and the current FOMC projection ("dot"). If the latest inflation data is the beginning of a sustained period of faster monthly price increases, then there is room for investors to reprice their expectations for both inflation and the funds rate (bottom two panels). There is a risk that the median FOMC rate projection for next year comes down a bit when the new "dots" are released after this week's FOMC meeting. Although with market-based inflation expectations firming, and survey-based measures holding steady near the Fed's 2% target amid easing financial conditions, the FOMC may choose to hold steady and wait to see if the August inflation data is the beginning of a trend - especially with the Fed set to announce the timing and details of the reduction of its balance sheet at this week's meeting. Downgrading interest rate expectations while also starting the unwind of the balance sheet could send a confusing message to markets. At the same time, any shift to a more hawkish or less dovish message from the Fed would be taken negatively by the Treasury market. The experience of Gilts last week is a warning sign about how unprepared investors are for a change in tone from central bankers. The language in the statement released after last week's BoE Monetary Policy Committee (MPC) meeting suggested that a rate hike may come within the next few months if U.K. economic growth evolves along the lines of the MPC's forecasts. That was enough to trigger a bear-flattening move in the Gilt curve, with the markets quickly pricing in one full additional rate hike by the BoE over the next year (Chart 2, second panel). A similar move could happen if the Fed were to send any new hawkish signals, although that is unlikely to occur at this week's FOMC meeting. We see a greater potential for the Fed's forecasts to be realized than the BoE's over the next year. Financial conditions have eased and leading indicators are still pointing to a reacceleration in U.S. growth in the coming months. The impact of the hurricanes in Texas and Florida will be a drag on growth in the 3rd quarter of this year, but this will not be enough to materially impact the Fed's growth forecasts for 2018. Meanwhile, the inflationary backdrop for the U.S. may finally be bottoming out, for a few reasons: 1. Our CPI diffusion index rising back above the 50 line in August (Chart 3, top panel), although additional gains will be necessary to herald a more sustained rise in core inflation. Chart 2Markets Have Bet Heavily##BR##On Central Bank Inaction Markets Have Bet Heavily On Central Bank Inaction Markets Have Bet Heavily On Central Bank Inaction Chart 3U.S. Inflation##BR##Stabilizing? U.S. Inflation Stabilizing? U.S. Inflation Stabilizing? 2. The U.S. labor market continues to tighten, with the gap between the "jobs plentiful" minus "jobs hard to get" indices from the Conference Board's consumer confidence survey widening to the widest level since 2001 (2nd panel), putting upward pressure on wage growth. 3. One of the biggest sources of the surprising downturn in core inflation seen in 2017, the plunge in wireless phone prices back in the spring, has fully stabilized (3rd panel). That decline alone represented a drag on the rate of inflation for core CPI services (excluding shelter) of 1.2 percentage points (bottom panel), and on overall core CPI inflation of around 35bps - ½ of the total decline in core CPI inflation since January. As the impact of that collapse in wireless charges falls out of the inflation data in the coming months, the drag on core CPI will fade. There is now a much better chance for the Fed's inflation forecasts to be realized next year, especially once the impact of a weaker dollar (and higher energy prices) is taken into account. While some of the doves on the FOMC may downgrade their inflation forecasts this week, a major reduction is unlikely in the absence of signs of a weakening U.S. labor market or renewed strength in the U.S. dollar. The U.S. backdrop contrasts sharply with what is going on in the U.K. While the labor market is even tighter there than in the U.S., the current upturn in U.K. inflation has also occurred alongside a sharp depreciation of the Pound since the 2016 Brexit vote (Chart 4). The currency has stabilized over the course of this year, with the year-over-year change in the BoE's trade-weighted index now nearly flat (bottom panel). Against this backdrop, inflation is more likely to peak out than reaccelerate from current levels. A similar argument can be made for the U.K. economy. Leading economic indicators have rolled over, while actual real GDP growth has decelerated (Chart 5, 3rd panel). Consumer confidence has steadily declined as the currency-driven inflation increase has eroded real income growth. This has created a very odd divergence between falling confidence and an increased market expectation for BoE rate hikes over the next year, which typically move in unison (bottom panel). Add in the ongoing uncertainties over Brexit that continue to weigh on business confidence and investment spending, and it is far more likely that the U.K. economy will lag versus the BoE's forecasts. Chart 4Currency Impact On U.K. Inflation Is Fading Currency Impact On U.K. Inflation Is Fading Currency Impact On U.K. Inflation Is Fading Chart 5Why Should The BoE Hike? Why Should The BoE Hike? Why Should The BoE Hike? For now, we are maintaining our recommended neutral allocation on Gilts in our model bond portfolio. Although we would view any additional widening in yield spreads between Gilts and U.S. Treasuries and core European yields as an opportunity to move to overweight. Simply put, the odds are far greater that the Fed's economic and inflation forecasts for the next year will be realized than those of the BoE, suggesting that there is more upside risk for yields in Treasuries than Gilts. Bottom Line: U.S. inflation data is stabilizing, while financial conditions continue to ease. The market is underestimating the potential for the Fed to hike rates again, perhaps as soon as December. At the same time, markets have priced in too many rate hikes in the U.K., with the Bank of England's growth and inflation forecasts unlikely to be realized. Maintain an overall below-benchmark portfolio duration tilt, while keeping an underweight stance on U.S. Treasuries and a neutral bias towards Gilts. Look to upgrade Gilts on any additional spread widening versus Treasuries or core Europe. Duration Checklist Update Back in February of this year, we introduced a list of indicators we need to monitor to determine if our recommended defensive duration stance on U.S. Treasuries and German Bunds was still warranted.1 These "Duration Checklists" combined data on overall global growth, as well as U.S. and Euro Area economic activity, inflation, investor risk-seeking behavior and technical positioning on government bonds. At the time, the Checklists were almost unanimous in pointing to a period of rising bond yields based on an improving growth profile and slowly rising inflation pressures. We updated the Checklists in May and, for the most part, the majority of the indicators were still flagging more upward pressures on yields, although some series on global growth and inflation had softened.2 With the benefit of hindsight, we now know that these factors - especially the pullback in U.S. inflation pressures - were enough to trigger a significant bond rally. With the U.S. inflation downdraft now in the process of stabilizing, as discussed earlier, this is now a good opportunity to revisit our Duration Checklists to assess the current backdrop for bond yields. The broad conclusion is that the majority of the indicators are still pointing to higher bond yields in the months ahead (Table 1). Table 1A Bearish Message From Our Duration Checklists Follow The Fed, Ignore The Bank Of England Follow The Fed, Ignore The Bank Of England Global economic activity indicators are mixed, but may be bottoming. The global leading economic indicator (LEI) continues to rise, heralding a continuation of the current economic uptrend (Chart 6). The breadth of that advance, however, is fading with our LEI diffusion index having fallen below the 50 line, meaning that there are more countries with a falling LEI. The global ZEW indicator of investor sentiment is also trending downward, another factor weighing on yields. The near-term dynamics on growth are starting to shift more bearishly for bonds, however, with the global data surprise index rising and the latest read on our Global Credit Impulse indicator ticking upward. We are giving a "check" to 3 of the 5 global growth elements in our Duration Checklists (LEI, data surprises, Credit Impulse), which represents a bond-bearish shift from the last update of the Checklists in May when only the LEI warranted a "check". Domestic economic growth in the U.S. and Euro Area is solid. Manufacturing PMIs in both the U.S. (the ISM index) and Europe are rising, as is consumer and business confidence (Charts 7 & 8). The latter is not surprising given the strong growth in corporate profits on both sides of the Atlantic that our models expect will continue. This bodes well for future growth momentum, as firms will not be forced to retrench on hiring and investment spending to protect profitability. We are giving a "check" to all domestic growth components of our Duration Checklists, highlighting that the economic backdrop remains bond bearish. Chart 6Yields Are Exposed To##BR##Improving Global Growth Yields Are Exposed To Improving Global Growth Yields Are Exposed To Improving Global Growth Chart 7A Solid U.S.##BR##Economic Expansion A Solid U.S. Economic Expansion A Solid U.S. Economic Expansion Chart 8European Growth Momentum##BR##Is Bearish For Bunds European Growth Momentum Is Bearish For Bunds European Growth Momentum Is Bearish For Bunds Realized inflation has dipped, but the worst looks to be over. In our Checklists, we include measures on energy prices, labor market tightness and wage inflation as the primary inflation indicators to monitor. On that front, the story still looks fairly benign for U.S. inflation given the dip in wage inflation measures like Average Hourly Earnings growth and the Atlanta Fed Wage Tracker (Chart 9). The unemployment gap (unemployment rate vs. NAIRU) is still negative, and other wage measures like the wage & salaries component Employment Cost Index are steadily expanding, suggesting that the underlying wage dynamics in the U.S. may not be as slow as indicated by Average Hourly Earnings. In the Euro Area, wage growth has accelerated above 2%, occurring alongside a grinding increase in core inflation and an unemployment gap that is almost fully closed (Chart 10). Meanwhile, the downward momentum in the growth of energy prices - denominated in both dollars and euros - has bottomed out after the sharp decline since the beginning of the year, although the rebound has been tepid so far (top panel of Charts 9 & 10). Chart 9Not Much Inflationary##BR##Pressures On UST Yields Not Much Inflationary Pressures on UST Yields Not Much Inflationary Pressures on UST Yields Chart 10Core Inflation & Wages Are##BR##Grinding Higher In Europe Core Inflation & Wages Are Grinding Higher In Europe Core Inflation & Wages Are Grinding Higher In Europe The most significant divergences between the regions exist within the inflation elements of our Checklists. For wage growth, we are giving an "x" to the U.S. but a "check" to Europe. For the unemployment gap, we are giving a "check" to both regions. For energy prices, however, we are not giving any indication (a "?") until we see more decisive evidence of a sustained acceleration that is pressuring headline inflation rates even higher. Both the Fed and ECB are biased to remove monetary accommodation. The Fed is in the midst of a rate-hiking cycle that began in late 2015, and is now about to begin the long process of shrinking its swollen balance sheet. The ECB has been slowly preparing the market for a shift to a slower pace of asset purchases, although rate hikes are still at least a couple of years away. For both central banks, we are giving a "check" for having a more hawkish/less dovish policy bias that is not bullish for bonds. Investors remain in risk-seeking mode. The way that we interpret investor risk aversion in the Checklists is if growth-sensitive risk assets like equities and corporate credit are rallying, then this is bearish for government bonds. The logic here is that private investor demand for Treasuries and Bunds is diminished when risk assets are rallying, as long as equities are not stretched to a point where the risks of a correction are elevated (i.e. indices trading 10% above their 200-day moving average). Also, the easing of financial conditions stemming from rallying stock and credit markets is a boost to growth that central banks will likely respond to by becoming less accommodative. From that perspective, the persistent bull markets in equities and corporate credit on both sides of the Atlantic are bearish for Treasuries (Chart 11) and Bunds (Chart 12). With stocks not looking stretched versus the medium-term trend and with volatility remaining low, all the related elements of our Checklists earn a "check". Chart 11Still A Pro-Risk Bias##BR##Among U.S. Investors Still A Pro-Risk Bias Among U.S. Investors Still A Pro-Risk Bias Among U.S. Investors Chart 12Still A Pro-Risk Bias##BR##Among Euro Area Investors Still A Pro-Risk Bias Among Euro Area Investors Still A Pro-Risk Bias Among Euro Area Investors Bond yields do not look stretched to the upside from a technical perspective. The Treasury sell-off from the 2017 peak back in March has pushed the 10-year yield back below its 200-day moving average, while also boosting the 6-month total return into positive territory (Chart 13). There is also a persistent net long position in 10-year Treasury futures (bottom panel). Add it all up and the technical backdrop for Treasuries is stretched in a way pointing to greater near-term risks of higher yields. In Europe, momentum measures all look neutral (Chart 14) and are no impediment to rising yields. We give all technical elements of our Duration Checklists a "check". Chart 13UST Rally Since March##BR##Is Looking Stretched UST Rally Since March Is Looking Stretched UST Rally Since March Is Looking Stretched Chart 14Neutral Technical##BR##Backdrop For Bunds Neutral Technical Backdrop For Bunds Neutral Technical Backdrop For Bunds Net-net, the Checklists show that the majority of indicators are still pointing to a bond-bearish backdrop. The only bond-bullish factors are the soft inflation readings in the U.S. although that may be in the process of shifting, as discussed earlier. There is not a major difference in the number of checkmarks for both the U.S. and Euro Area Checklists, thus we see no reason to favor either market from a relative perspective - there is pressure for both Treasury and Bund yields to rise. Thus, we are maintaining our recommended below-benchmark medium-term duration stance in both the U.S. and core Europe within hedged global bond portfolios. Chart 15UST Yields Have More Near-Term Upside UST Yields Have More Near-Term Upside UST Yields Have More Near-Term Upside From a shorter-term tactical perspective, however, we see more upside for Treasury yields vs Bunds with U.S. economic data surprising to the upside at a faster pace than in Europe (Chart 15). Throw in the potential for U.S. inflation to also rise above depressed expectations and a wider Treasury-Bund spread - a trade that we currently have in our Tactical Overlay portfolio and which goes against the tightening currently priced into the forwards - is the more likely outcome in the next few months. Bottom Line: An update of our Duration Checklists shows that the backdrop for growth, inflation and investor risk appetite remains bearish for U.S. Treasuries and German Bunds. Maintain below-benchmark duration exposure to both markets on a medium-term basis. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Special Report, "A Duration Checklist For U.S. Treasuries & German Bunds", dated February 15th 2017, available at gfis.bcaresearch.com. 2 Please see BCA Global Fixed Income Strategy Special Report, "Fade The "Trump Fade"", dated May 23rd 2017, available at gfis.bcaresearch.com. Follow The Fed, Ignore The Bank Of England Follow The Fed, Ignore The Bank Of England Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns