Japan

Special Report

Highlights US Election & Duration: We estimate that there is an 80% probability of a US election result that will give a lift to US Treasury yields via increased fiscal stimulus. Those are strong enough odds to justify a move to a below-benchmark cyclical US duration stance on a 6-12 month horizon. US Treasuries: We anticipate a moderate bear market in US Treasuries to unfold during the next 6-12 months. In addition to below-benchmark portfolio duration, investors should overweight TIPS versus nominal Treasuries, hold nominal and real yield curve steepeners, and hold inflation curve flatteners. Non-US Country Allocation: Within global government bond portfolios, downgrade the US to underweight. Favor countries that have lower sensitivity to rising US Treasury yields with central banks that are likely to be more dovish than the Fed in the next few years. That means increasing allocations to core Europe and Japan, while reducing exposure to Canada and Australia. Stay neutral on the UK given the near-term uncertainties over the final Brexit outcome. Feature With the US presidential election just two weeks away, public opinion polls continue to show that Joe Biden is the favorite to win the White House. However, the odds of a “Blue Sweep” - combining a Biden victory with the Democratic Party winning control of both the US Senate and House of Representatives - have increased since the end of September according to online prediction markets. US Treasury yields have also moved higher over that same period (Chart 1), which we interpret as the bond market becoming more sensitive to the likelihood of a major increase in US government spending under single-party Democratic control. Chart 1A Blue Sweep Is Bond Bearish According to a recent analysis done by the Committee for a Responsible Federal Budget, President Trump’s formal policy proposals would increase US federal debt by $4.95 trillion between 2021 and 2030, while Biden’s plan would increase the debt by $5.60 trillion (Table 1).1 While those are both massive fiscal stimulus plans, there is a stark difference in the policy mix of their proposals that matters for the future path of US bond yields. Table 1A Comparison Of The Candidates' Budget Proposals Under Biden, spending is projected to increase by a cumulative $11.1 trillion, partially offset by $5.8 trillion in revenue increases and savings with the former vice-president calling for tax hikes on corporations and high-income earners. On the other hand, Trump’s plan includes $5.45 trillion of spending increases and tax cuts over the next decade, offset by $0.75 trillion in savings. Conclusion: Biden would increase spending by over twice that of a re-elected Trump, with much of that spending expected to be front-loaded in the early part of his first term. Outright spending is more reflationary than tax cuts because it puts more money in the pockets of consumers (spenders) relative to producers (savers). The Biden plan would be more stimulating for overall activity even if the increase in debt is about the same. Another analysis of the Biden and Trump platforms was conducted by Moody’s in September, based on estimates of how much of each candidate’s promises could be successfully implemented under different combinations of White House and Congressional control.2 The stimulus figures were run through the Moody’s US economic model, which is similar to the budget scoring model of the US Congressional Budget Office, to produce a year-by-year path for the US economy over the next decade (Chart 2). Chart 2The Biden Platform Is Highly Stimulative Moody’s concluded that the US economy would return to full employment in the second half of 2022 under a President Biden – especially if the Democrats win the Senate - compared to the first half of 2024 under a re-elected President Trump. Such a rapid closing of the deep US output gap that opened up because of the COVID-19 recession would likely trigger a reassessment of the Fed’s current highly dovish policy stance. The US output gap would close more rapidly under a President Biden, likely triggering a reassessment of the Fed’s current highly dovish policy stance.  At the moment, the US overnight index swap (OIS) curve discounts one full 25bp Fed hike by late 2023/early 2024, and two full hikes by late 2024/early 2025 (Chart 3). This pricing of the future path of interest rates has occurred even with the Fed promising to keep the funds rate anchored near 0% until at least the end of 2023. The likelihood of some form of increased fiscal spending after the election will cause the bond market to challenge the Fed’s current forward guidance even more, putting upward pressure on Treasury yields. Chart 3US Fiscal Stimulus Will Pull Forward Fed Liftoff Our colleagues at BCA Geopolitical Strategy see a Blue Sweep as the most likely outcome of the US election, although their forecasting models suggest that the race for control of the Senate will be much closer than the Biden vs Trump battle (there is little chance that control of the House of Representatives would switch back to the Republicans).3 Their scenarios for each of the White House/Senate combinations, along with their own estimated probability for each, are the following: Biden wins in a Democratic sweep: BCA probability = 45%. The US economy will benefit from higher odds of unfettered fiscal stimulus in 2021, although financial markets will simultaneously have to adjust for the negative shock to US corporate earnings from higher taxes and regulation. Government bond yields should rise on the generally reflationary agenda. Trump wins with a Republican Senate: BCA probability = 30%. In this status quo scenario, a re-elected President Trump would still face opposition from House Democrats on most domestic economic issues, forcing him to tilt towards more protectionist foreign and trade policies in his second term. Fiscal stimulus would be easy to agree, though not as large as under a Democratic sweep. US Treasury yields would rise, but would later prove volatile due to the risk to the cyclical recovery from a global trade war, as Trump’s tariffs will not be limited to China and could even affect the European Union. Biden wins with the Senate staying Republican: BCA probability = 20%. This is ultimately the most positive outcome for financial markets - reduced odds of a full-blown trade war with China, combined with no new tax hikes. Bond yields would drift upward over time, but not during the occasional fiscal battles that would ensue between the Democratic president and Republican senators. The first such battle would start right after the election. Treasuries would remain well bid until financial market pressures forced a Senate compromise with the new president sometime in H1 2021. Trump wins with a Democratic Senate: BCA probability = 5%. This is the least likely scenario but one that could produce a big positive fiscal impulse. Trump is a big spender and will veto tax hikes, but will approve populist spending on areas where he agrees. The Democratic Senate would not resist Trump’s tough stance on China, however, thus keeping the risk of US-China trade skirmishes elevated. This is neutral-to-bearish for US Treasuries, depending on the size of any bipartisan stimulus measures and Trump’s trade actions. The key takeaway is that the combined probability of scenarios that will put upward pressure on US Treasury yields is 80%, versus a 20% probability of a more bond-neutral outcome. That is a bond-bearish skew worth positioning for by reducing US duration exposure now, ahead of the November 3 election. Of this 80%, 35 percentage points come from scenarios in which President Trump would remain in power. Hence his trade wars would eventually undercut his reflationary fiscal policy. This would become the key risk to the short duration view after the initial market response. Bottom Line: The most likely scenarios for the US election will give a cyclical lift to US Treasury yields via increased fiscal stimulus. This justifies a move to a below-benchmark US duration stance on a 6-12 month horizon. If Trump is re-elected, the timing of Trump’s likely return to using broad-based tariffs will have to be monitored closely. A Moderate Bear Market Chart 4Less Election-Day Upside Than In 2016 While our anticipated Blue Sweep election outcome will lead to a large amount of fiscal spending in 2021 and beyond, we anticipate only a modest increase in bond yields during the next 6-12 months. In terms of strategy, our recommended reduction in portfolio duration reflects the fact that fiscal largesse meaningfully reduces the risk of another significant downleg in bond yields and strengthens our conviction in a moderate bear market scenario for bonds. This does raise the question of how large an increase in US Treasury yields we expect during the next 6-12 months. We turn to this question now. Not Like 2016 First, we do not expect a massive election night bond rout like we saw in 2016 (Chart 4). For one thing, the Fed was much more eager to tighten policy in 2016 than it is today, and it did deliver a rate hike one month after the Republicans won the House, Senate and White House (Chart 4, bottom panel). This time around, the Fed has made it clear that it will wait until inflation is running above its 2% target before lifting rates off the zero bound and will not respond directly to expectations for greater fiscal stimulus. A complete re-convergence to long-run fed funds rate estimates would impart 80 – 100 bps of upward pressure to the 5-year/5-year forward Treasury yield. Second, 2016’s election result was mostly unanticipated. This led to a dramatic adjustment in market prices once the results came in. The PredictIt betting market odds of a “Red Sweep” by the Republicans in 2016 were only 16% the night before the election. As of today, the betting markets are priced for a 58% chance of a Blue Sweep in 2020. Unlike in 2016, bonds are presumably already partially priced for the most bond-bearish election outcome. A Slow Return To Equilibrium To more directly answer the question of how high bond yields can rise, survey estimates of the long-run (or equilibrium) federal funds rate provide a useful starting point. In a world where the economy is growing at an above-trend pace and inflation is expected to move towards the Fed’s target, it is logical for long-maturity Treasury yields to settle near estimates of the long-run fed funds rate. Indeed, this theory is borne out empirically. During the last two periods of robust global economic growth (2017/18 & 2013/14), the 5-year/5-year forward Treasury yield peaked around levels consistent with long-run fed funds rate estimates (Chart 5). As of today, the median estimates of the long-run fed funds rate from the New York Fed’s Survey of Market Participants and Survey of Primary Dealers are 2% and 2.25%, respectively. In other words, a complete re-convergence to these equilibrium levels would impart 80 – 100 bps of upward pressure to the 5-year/5-year forward Treasury yield. We expect this re-convergence to play out eventually, but probably not within the next 6-12 months. In both prior periods when the 5-year/5-year forward Treasury yield reached these equilibrium levels, the Fed’s reaction function was much more hawkish. The Fed was hiking rates throughout 2017 & 2018 (Chart 5, panel 4), and the market moved quickly to price in rate hikes in 2013 (Chart 5, bottom panel). The Fed’s new dovish messaging will ensure that the market reacts less quickly this time around. Also, continued curve steepening will mean that the 5-year/5-year forward yield’s 80 – 100 bps of upside will translate into significantly less upside for the benchmark 10-year yield. The 10-year yield and 5-year/5-year forward yield peaked at similar levels in 2017/18 when the Fed was lifting rates and the yield curve was flat (Chart 6). But, the 10-year peaked far below the 5-year/5-year yield in 2013/14 when the Fed stayed on hold and the curve steepened. Chart 5How High For Treasury Yields? Chart 6Less Upside In 10yr Than In 5y5y The next bear move in bonds will look much more like 2013/14. The Fed will keep a firm grip over the front-end of the curve, leading to curve steepening and less upside in the 10-year Treasury yield than in the 5-year/5-year forward. In addition to shifting to a below-benchmark duration stance, investors should maintain exposure to nominal yield curve steepeners. Specifically, we recommend buying the 5-year note versus a duration-matched barbell consisting of the 2-year and 10-year notes (Chart 6, bottom panel).4 TIPS Versus Nominals We have seen that a full re-convergence to “equilibrium” implies 80 – 100 bps of upside in the 5-year/5-year forward nominal Treasury yield. Bringing TIPS into the equation, we have also observed that long-maturity (5-year/5-year forward and 10-year) TIPS breakeven inflation rates tend to settle into a range of 2.3 – 2.5 percent when inflation is well-anchored and close to the Fed’s target (Chart 7). The additional fiscal stimulus that will follow a Blue Sweep election makes it much more likely that the economic recovery will stay on course, leading to an eventual return of inflation to target and of long-maturity TIPS breakeven inflation rates to a 2.3 – 2.5 percent range. However, as with nominal yields, this re-convergence will be a long process whose pace will be dictated by the actual inflation data. To underscore that point, consider that our Adaptive Expectations Model of the 10-year TIPS breakeven inflation rate – a model that is driven by trends in the actual inflation data – has the 10-year breakeven rate as close to fair value (Chart 8).5 This fair value will rise only slowly over time, alongside increases in actual inflation. Chart 7Overweight TIPS Versus Nominals Chart 8Real Yields Have Likely Bottomed All in all, we continue to recommend an overweight allocation to TIPS versus nominal Treasuries. TIPS breakeven inflation rates will move higher during the next 6-12 months, but are unlikely to reach our 2.3 – 2.5 percent target range within that timeframe. TIPS In Absolute Terms As stated above, we expect nominal yields to increase more than real yields during the next 6-12 months, but what about the absolute direction of real (aka TIPS) yields? Here, our sense is that real yields have also bottomed. If we consider the extreme scenario where the 5-year/5-year forward nominal yield returns to its equilibrium level and where long-maturity TIPS breakeven inflation rates return to our target range, it implies about 80 bps of upside in the nominal yield and 40 bps of upside in the breakeven. This means that the 5-year/5-year real yield has about 40 bps of upside in a complete “return to equilibrium” scenario. While we don’t expect this “return to equilibrium” to be completed within the next 6-12 months, the process is probably underway. The only way for real yields to keep falling in this reflationary world is for the Fed to become increasingly dovish, even as growth improves and inflation rises. After its recent shift to an average inflation target, our best guess is that Fed rate guidance won’t get any more dovish from here. Real yields fell sharply this year as the market priced in this change in the Fed’s reaction function, but the late-August announcement of the Fed’s new framework will probably mark the bottom in real yields (Chart 8, bottom panel).6 Two More Curve Trades Chart 9Own Inflation Curve Flatteners And Real Curve Steepeners In addition to moving to below-benchmark duration, maintaining nominal yield curve steepeners and staying overweight TIPS versus nominal Treasuries, there are two additional trades that investors should consider in order to profit from the reflationary economic environment. The first is inflation curve flatteners. The cost of short-maturity inflation protection is below the cost of long-maturity inflation protection, meaning that it has further to run as inflation returns to the Fed’s target (Chart 9). In addition, if the Fed eventually succeeds in achieving a temporary overshoot of its inflation target, then we should expect the inflation curve to invert. Real yield curve steepeners are in some ways the mirror image of inflation curve flatteners. Assuming no change in nominal yields, the real yield curve will steepen as the inflation curve flattens. But what makes real yield curve steepeners look even more attractive is that increases in nominal yields during the next 6-12 months will be concentrated in long-maturities. This will impart even more steepening pressure to the real yield curve. Investors should continue to hold inflation curve flatteners and real yield curve steepeners. Bottom Line: We anticipate a moderate bear market in US Treasuries to unfold during the next 6-12 months. In addition to below-benchmark portfolio duration, investors should overweight TIPS versus nominal Treasuries, hold nominal and real yield curve steepeners, and hold inflation curve flatteners. Non-US Government Bonds: Reduce Exposure To US Treasuries The mildly bearish case for US Treasuries that we have laid out above not only matters for our recommended duration stance, but also for our suggested country allocation within global government bond portfolios. Simply put, the risk of rising bond yields is much higher in the US than elsewhere, both for the immediate post-election period but also over the medium-term. Thus, the immediate obvious portfolio decision is to downgrade US Treasuries to underweight. The move higher in US Treasury yields that we expect is strictly related to spillovers from likely US fiscal stimulus. While other countries in the developed world are contemplating the need for additional fiscal measures, particularly in Europe where there is a renewed surge in coronavirus infections and growing economic restrictions, no country is facing as sharp a policy choice as the US with its upcoming election. The Fed has purchased 57% of all US Treasuries issued since late February of this year, in sharp contrast to the ECB and Bank of Japan that have purchased over 70% of euro area government bonds and JGBs issued. We can say with a fair degree of certainty that the US will have a relatively more stimulative fiscal policy stance than other developed economies over at least the next couple of years. This implies a higher relative growth trajectory for the US that hurts Treasuries more on the margin than non-US government debt. Chart 10The Fed Will Gladly Trade Less QE For More Fiscal Stimulus In addition, the likely path of relative monetary policy responses are more bearish for US Treasuries. As described above, the scope of the US stimulus will cause bond investors to further question the Fed’s commitment to keeping the funds rate unchanged for the next few years. That also applies to the Fed’s other policy tools, like asset purchases. The Fed is far less likely to continue buying US Treasuries at the same aggressive pace it has for the past eight months if there is less need for monetary stimulus because of more fiscal stimulus. According to the IMF, the Fed has purchased 57% of all US Treasuries issued since late February of this year, in sharp contrast to the ECB and Bank of Japan that have purchased over 70% of euro area government bonds and JGBs issued (Chart 10). If US Treasury yields are rising because of improving US growth expectations, fueled by fiscal stimulus, the Fed will likely tolerate such a move and buy an even lower share of Treasuries issued – particularly if the higher bond yields do not cause a selloff in US equity markets that can tighten financial conditions and threaten the growth outlook. The fact that US equities have ignored the rise in Treasury yields seen since the end of September may be a sign that both bond and stock investors are starting to focus on a faster trajectory for US growth. In terms of country allocation, beyond downgrading US Treasuries to underweight, we recommend upgrading exposure to countries that are less sensitive to changes in US Treasury yields (i.e. countries with a lower yield beta to changes in US yields). In Chart 11, we show the rolling beta of changes in 10-year government bond yields outside the US to changes in 10-year US Treasury yields. This is a variation of the “global yield beta” concept that we have discussed in the BCA Research bond publications in recent years. Here, we modify the idea to look at which countries are more or less correlated to US yields, specifically. A few points stand out from the chart: Chart 11Reduce Exposure To Bond Markets More Correlated To UST Yields All countries have a “US yield beta” of less than 1, suggesting that Treasuries are a consistent outperformer when US yields fall and vice versa. This suggests moving to underweight the US when US yields are rising is typically a winning strategy in a portfolio context. The list of higher beta countries includes Canada, Australia, New Zealand, the UK and Germany; although Canada stands out as having the highest yield beta in this group. The list of lower beta countries includes France, Italy, Spain, and Japan. In Chart 12, we show what we call the “upside yield beta” that is estimated only using data for periods when Treasury yields are rising. This gives a sense of which countries are more likely to outperform or underperform during a period of rising Treasury yields, as we expect to unfold after the election. From this perspective, the “safer” lower US upside yield beta group includes the UK, France, Germany and Japan. The riskier higher US upside yield beta group includes Canada, Australia, New Zealand, Italy and Spain. Chart 12Favor Bond Markets Less Correlated to RISING UST Yields Spain and Italy are less likely to behave like typical high-beta countries as US yields rise, however, because the ECB is likely to remain an aggressive buyer of their government bonds as part of their asset purchase programs over the next 6-12 months. We also do not recommend trading UK Gilts off their yield beta to US Treasuries in the immediate future, given the uncertainties over the negotiations over a final Brexit deal. Both sets of US yield betas suggest higher-beta Canada, Australia and New Zealand are more at risk of relative underperformance versus lower-beta France, Germany and Japan. In terms of government bond country allocation, we recommend reducing exposure to the former group and increasing allocations to the latter group. Bottom Line: Within global government bond portfolios, downgrade the US to underweight. Favor countries that have lower sensitivity to rising US Treasury yields, especially those with central banks that are likely to be more dovish than the Fed in the next few years. That means increasing allocations to core Europe and Japan, while reducing exposure to “higher-beta” Canada and Australia.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 http://www.crfb.org/papers/cost-trump-and-biden-campaign-plans 2 https://www.moodysanalytics.com/-/media/article/2020/the-macroeconomic-consequences-trump-vs-biden.pdf 3 Please see BCA Research Geopolitical Strategy Special Report, “Introducing Our Quantitative US Senate Election Model”, dated October 16, 2020, available at gps.bcaresearch.com 4 For more details on this recommended steepener trade please see US Bond Strategy Weekly Report, “Positioning For Reflation And Avoiding Deflation”, dated August 11, 2020, available at usbs.bcaresearch.com 5 For more details on our Adaptive Expectations Model please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com 6 For a detailed look at the implications of the Fed’s policy shift please see US Bond Strategy / Global Fixed Income Strategy Special Report, “A New Dawn For US Monetary Policy”, dated September 1, 2020, available at usbs.bcaresearch.com

To all clients, Next week, in lieu of publishing a regular report, I will be hosting a webcast on September 15th at 10 am EDT, discussing our latest views on global fixed income markets.  Sign up details for the Webcast will arrive in your inboxes later this week.   Best regards, Robert Robis, Chief Fixed Income Strategist   Feature Much of the global rebound in economic activity, and recovery in equity and credit markets, seen since the COVID-19 shock earlier this year can be attributed to historic levels of monetary and fiscal stimulus. However, the effective transmission of various monetary policy measures such as liquidity injections and refinancing operations, and by extension a sustained global recovery, is dependent on the continued smooth flow of credit from lenders to borrowers. As such, the tightening in bank lending standards seen across developed markets in the second quarter of 2020 could imperil the recovery if banks remain cautious with borrowers (Chart 1). Chart 1Credit Standards Across Developed Markets This week, we are introducing the BCA Research Global Fixed Income Strategy (GFIS) Global Credit Conditions Chartbook—a review of central bank surveys of bank lending standards and loan demand.  We will be publishing this chartbook on an occasional basis going forward to help inform our fixed income investment recommendations. Where it is relevant to our analysis, we will also make special note of the one-off questions asked in some of these surveys that are germane to the economic situation at hand. Where To Find The Bank Lending Surveys A number of central banks publish regular surveys of bank lending conditions in their domestic economies. The surveys, and the details on how they are conducted, can be found on the websites of the central banks: US Federal Reserve:  https://www.federalreserve.gov/data/sloos.htm European Central Bank: https://www.ecb.europa.eu/stats/ecb_surveys/bank_lending_survey/html/index.en.html Bank of England: https://www.bankofengland.co.uk/credit-conditions-survey/ Bank of Japan: https://www.boj.or.jp/en/statistics/dl/loan/loos/index.htm/ Bank of Canada: https://www.bankofcanada.ca/publications/slos/ Reserve Bank of New Zealand: https://www.rbnz.govt.nz/statistics/c60-credit-conditions-survey US Chart 2US Credit Conditions Overall credit standards for US businesses, measured as an average of standards faced by small, medium and large firms, tightened dramatically in Q2/2020 (Chart 2). Unsurprisingly, gloomier economic outlooks, reduced risk tolerance, and worsening industry-specific problems were the top reasons cited by US banks for tightening standards. US banks reported that commercial and industrial (C&I) loan demand from all firms also weakened in Q2, owing to a decrease in customers’ inventory financing and fixed investment needs. This suggests that the surge in actual C&I loan growth data during the spring was fueled by companies drawing down credit lines to survive the lack of cash flow during the COVID-19 lockdowns and should soon peak. Standards for consumer loans tightened significantly in Q2, as well. A continuation of this trend would pose a major risk to the US economic recovery, given the still fragile state of US consumer confidence. Business lending standards typically lead US high-yield corporate bond default rates by about one year, suggesting that defaults will continue to climb over the next few quarters (Chart 2, top panel). Tightening US junk bond spreads have ignored the rising trend in defaults and now provide no compensation for the likely amount of future default losses, suggesting poor value in the overall US high-yield market (Chart 3). Turning to the real estate market, lending standards have tightened significantly for both commercial and residential mortgage loans (Chart 4). In a special question asked in the Q2 survey, US banks indicated that lending standards for both those categories are at the tighter end of the range that has prevailed since 2005. Business lending standards typically lead US high-yield corporate bond default rates by about one year, suggesting that defaults will continue to climb over the next few quarters. Chart 3US Junk Spreads Do Not Compensate For Default Risk Chart 4The White Picket Fence Is Looking Out Of Reach Euro Area Italy is seeing the greater benefit from ECB support, however, with loan growth now at a new cyclical high. Chart 5Euro Area Credit Conditions In contrast to the US, credit standards actually eased slightly in the euro area in Q2/2020 (Chart 5). Banks reported increased perceptions of overall risk from a worsening economic outlook, but that was more than offset by the massive liquidity and loan guarantee programs that were part of the policy response to the COVID-19 recession. Going forward, banks expect lending standards to tighten as the maximum impact of those policies begins to fade. Credit demand from firms rose in Q2, driven by acute liquidity needs during the COVID-19 lockdowns. At the same time, demand for longer-term financing for capital expenditure was very depressed. Banks expect credit demand to normalize in Q3, as easing lockdown restrictions dampen the immediate need for liquidity. Credit demand from euro area households plummeted in Q2. Banks reported that plunging consumer confidence was the leading cause of decline in credit demand, followed closely by reduced spending on durable goods. Consumer confidence has already rebounded and banks expect demand to follow suit, as economies re-open and spending opportunities return. Chart 6HY Spreads In The Euro Area Are Unattractive As with the US, we expect that tighter credit standards to firms will drive up euro area high-yield default rates. Current euro area high-yield spreads offer little compensation for the coming increase in default losses, suggesting a similar poor valuation backdrop to US junk bonds (Chart 6). Looking at the four major euro area economies, credit standards eased across the board in Q2, with the largest moves seen in Italy and Spain (Chart 7). The ECB’s liquidity operations have helped support lending in those countries, each with a take-up from long-term refinancing operations (LTROs) equal to around 14% of total bank lending (Chart 8). Italy is seeing the greater benefit from ECB support, however, with loan growth now at a new cyclical high and Spanish banks projecting a much sharper tightening of lending standards in Q3 relative to Italian banks.   Chart 7Loan Growth Accelerating Across Most Of The Euro Area Chart 8Italy & Spain Taking Full Advantage Of LTROs UK For consumers, UK banks are projecting loan demand to improve in Q3, although that will require a sharper rebound in consumer confidence than has been seen to date. Chart 9UK Credit Conditions In the UK, corporate credit standards eased significantly in Q2 2020 thanks to the massive liquidity support programs provided by the UK government (Chart 9). Lenders reported a larger proportion of loan application approvals from all business sizes, with the greatest improvements seen in small businesses and medium-sized private non-financial corporations (PNFCs). However, lenders indicated that average credit quality on new PNFC borrowing facilities had actually declined, with default rates increasing, for all sizes of borrowers. This divergence between increased lending and declining borrower creditworthiness attests to the impact of the UK’s substantial liquidity provisions in response to the COVID-19 shock.   The credit demand side mirrors the supply story with a massive spike in Q2 2020. In contrast to euro area counterparts, UK businesses reportedly borrowed primarily to facilitate balance sheet restructuring. However, as with the euro area, the story for Q3 is much more bearish. Banks are projecting credit standards to turn more restrictive as stimulus programs run out and borrowers rein in credit demand. Going forward, decreasing risk appetite of UK banks will likely contribute to a tightening in lending standards. For consumers, UK banks are projecting loan demand to improve in Q3, although that will require a sharper rebound in consumer confidence than has been seen to date. UK banks surprisingly reported that the average credit quality of new consumer loans improved in Q2, suggesting that consumer loan demand could rebound strongly in Q3 as lockdown restrictions fade.   Japan Perversely, the latest improvement in Japanese business optimism could translate to lower business loan demand going forward. Chart 10Japan Credit Conditions Before the pandemic hit, credit standards in Japan were in a structural tightening trend for both firms and households (Chart 10). Fiscal authorities have taken a number of measures to ease conditions for businesses, including low interest rate loan programs and guarantees for large businesses as well as small and medium-sized enterprises, which has translated into the easiest credit standards for Japanese firms since 2005. The correlation between business loan demand and business conditions is not as clear-cut in Japan compared to other countries. Japanese firms tend to borrow more when the economic outlook is poor, indicating that loans are being used to meet emergency funding or restructuring needs rather than being put towards capital expenditure or inventory financing. Perversely, the latest improvement in Japanese business optimism could translate to lower business loan demand going forward. However, the consumer picture is a bit more conventional—consumer loan demand and confidence tend to track quite closely. While consumer confidence has yet to stage a convincing rebound, it has clearly bottomed. The more positive projections for consumer loan demand from the Japan bank lending survey seem to confirm this message.  Canada And New Zealand In Canada, business lending standards tightened in Q2/2020 as loan growth slowed (Chart 11). Although loan growth is far from contracting on a year-on-year basis, further tightening in conditions could pose an obstacle to Canadian recovery. On the mortgage side, the Canadian government has been active in easing pressures for lenders by relaxing loan-to-value requirements for mortgage insurance, making it easier for them to collateralize and sell their assets to the Canadian Mortgage and Housing Corporation (CMHC). Although this has yet to translate to the standards faced by borrowers, residential mortgage growth remains buoyant. In New Zealand, credit standards for firms (including both corporates and SMEs) tightened significantly in Q2 (Chart 12). Many banks expect to apply tighter lending standards to borrowers in industries most impacted by the pandemic, such as tourism, accommodation, and construction. Demand for credit from firms was driven by working capital needs while capital expenditure funding demands fell drastically. Chart 11Canada Credit Conditions Chart 12New Zealand Credit Conditions   On the consumer side, residential mortgage standards increased somewhat, and banks expect to perform more due diligence on income and job security. The hit to credit demand was broad-based across credit card, secured, and unsecured lending and coincided with a sharp fall in loan demand.     Shakti Sharma Research Associate ShaktiS@bcaresearch.com ​​​​​​​​​​​​​​Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index ​​​​​​​ Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Stocks, particularly tech stocks, are technically overbought and highly vulnerable to a further correction. Nevertheless, investors should continue to overweight global equities relative to bonds on a 12-month horizon, while rotating equity allocations into cheaper sectors and regions. What should policymakers do if they wish to maximize growth and restore full employment? In the feature section of this report, we argue that the optimal course of action for most countries is to loosen fiscal policy until labor slack has been eliminated and the central bank’s inflation target has been met. Once this has been achieved, governments should trim the budget deficit to keep inflation from accelerating too much. What will policymakers actually do? While today’s budget deficits are smaller than what most economies need, they will ultimately prove to be too big once private sector demand recovers. The upshot is that inflation will increase by the middle of the decade, first in the US and then everywhere else. The secular bull market in equities will end only when central banks are forced to scramble to contain inflation. Fortunately, that day of reckoning is at least a few years away. Feature Apparently, Stocks Don’t Always Go Up After a relentless rally, stocks buckled under the pressure on Thursday. The MSCI All-Country World index lost 3%, the S&P 500 shed 3.5%, and the tech-heavy Nasdaq Composite plunged 5%. Two weeks ago, in a report titled “The Return Of Nasdog,” we argued that the leadership role was set to pivot away from tech and health care, as pandemic angst subsided and investors began to price in a recovery in the sectors of the stock market that had been crushed by lockdown measures. Chart 1A Weaker Dollar Is Generally Associated With Non-US Equity Outperformance, But Not Since The Covid Crash Historically, non-US equities have outperformed their US peers when the dollar has weakened (Chart 1). This relationship broke down this year because of the outsized weight that tech and health care command in US indices. If the relative performance of tech and health care stocks peaks over the coming weeks, this should translate into a clear outperformance for non-US stock markets. Value stocks should also start outperforming growth stocks. Stock market leadership changes often occur within the context of broad-based equity corrections. Our near-term view on stocks, as illustrated in the view matrix at the end of this report, is more cautious than our 12-month view. Thus, we would not be surprised if the major indices sell off over the coming weeks, with tech stocks leading the way down. The same sort of technical factors that amplified the move up in stocks over the past few weeks could exacerbate the move down. Most notably, so-called delta hedge option strategies, in which an investor sells calls and hedges the risk by purchasing the underlying stock, can create a self-reinforcing feedback loop where rising call prices force investors to buy more shares, leading to even higher call prices. Once the stock market starts falling, the process goes into reverse. Nevertheless, we do not expect tech stocks to suffer the sort of crash they experienced in 2000. Tech valuations are not as stretched as they were back then, earnings growth is stronger, and balance sheets are much healthier. Moreover, unlike in 2000, when the Fed lifted rates to as high as 6.5% in May, monetary policy is at no risk of turning hawkish. All this suggests that tech stocks are more likely to go sideways than down over a 12-month horizon (albeit in a fairly volatile manner). Investors should continue to overweight global equities relative to bonds on a 12-month horizon, while tilting equity allocations towards cheaper sectors and regions. Feature: Should Versus Will Investors want to know what the future will bring. As such, our primary interest at BCA Research is in predicting what policymakers will do rather than what they should do. Sometimes, however, it is useful to ask the “should” question since the answer may shape one’s view on the “will” question. This is especially the case when a particular set of goals is aligned with both the incentives and constraints that policymakers face. With that in mind, let us ask what the optimal mix of monetary and fiscal policy should be, assuming that policymakers have the goal of maximizing growth and moving the economy towards full employment. As we argue below, this is a relevant question to ask not because we necessarily share this goal – our personal value judgments are besides the point here – but because most policymakers think this is the correct goal. Propping Up Demand Chart 2Labor Markets In Developed Economies Have Rarely Overheated Over The Past Few Decades Maintaining full employment requires that spending match the economy’s productive capacity. In theory, this should not be a difficult objective to achieve. After all, people like to spend. Increasing demand should be easy. The hard part should be raising supply. In practice, it has not worked out that way. Even before the pandemic, unemployment rates rarely fell below their full employment level across the G7 economies (Chart 2). High Unemployment: Cyclical Or Structural? Some will argue that surplus unemployment is necessary to shift workers from sectors of the economy where they are not needed to sectors where they are. The failure to facilitate such resource reallocation could, it is alleged, stymie long-term growth. This is largely a spurious claim. As Chart 3 shows, there is always a huge amount of churn in the labor market. In 2019, a year in which total employment rose by 2.1 million, a total of 70 million people were hired in the US compared to 64 million who quit or lost their jobs. In fact, labor market churn tends to decrease during recessions as workers become reluctant to quit their jobs. Chart 3Labor Market Turnover Tends To Increase During Expansions Chart 4Residential Construction Accounted For Less Than 20% Of The Job Losses During The Great Recession Far from reflecting structural factors, the vast majority of the rise in joblessness during economic downturns is gratuitous in nature. For example, more than 80% of the jobs lost during the Great Recession were outside the residential real estate sector (Chart 4). Moreover, employment growth is highly correlated with investment spending (Chart 5). The easiest way to induce firms to boost capex – and, in the process, augment the economy’s productive capacity – is to adopt policies that raise overall employment. A stronger labor market will generate more demand for goods and services. It will also make labor more expensive in relation to capital, thereby incentivizing labor-saving capital investment. Chart 5Employment Growth And Investment Spending Go Hand-In-Hand Today, unemployment is elevated once again. As was the case during prior recessions, some workers will need to transition from sectors of the economy that will be slow to recover (retail, travel, and hospitality, for example) to sectors where jobs will be more plentiful. The risk is that there will not be enough job vacancies in the latter sectors to compensate for job losses in the former. The fact that permanent job losses have been creeping higher in the US over the past few months, even as temporary layoffs have come down, is evidence that such an outcome is a clear and present danger (Chart 6). Chart 6Many Are Returning To Work, But The Number Of Permanent Layoffs Is Slowly Increasing As Well Central Banks Can’t Do It All One does not need to refill a leaky bucket through the same hole the water escaped. As long as there is enough demand throughout the economy, workers who lose their jobs in declining sectors will eventually find new jobs in other sectors. So why has the bucket seemed chronically short of water in recent years? The answer is that monetary policy has been tasked to do more than it is realistically capable of achieving. Monetary policy operates with “long and variable lags.” When unemployment rises, the best that central banks can do is cut interest rates and hope that the more interest-rate sensitive parts of the economy eventually perk up. If the interest-rate sensitive sectors of the economy are tapped out, just as housing was following the financial crisis, or policy rates are near their lower bound, as they are now, monetary policy will be even less potent than usual. The Role Of Fiscal Policy This is where fiscal policy ought to fill the void. Even if monetary policy is exhausted, governments can cut taxes, raise transfers to households and businesses, or increase direct spending on goods and services. The extent to which fiscal policy is loosened should not be preordained. Rather, it should simply reflect the state of the economy. There is no limit to how much money governments can transfer to the public. In fact, one can easily imagine a system where governments cut taxes and increase transfer payments whenever unemployment moves up. Such a powerful system of automatic stabilizers would go a long way towards keeping the economy on an even keel. Why have governments been reluctant to embrace such a system? One key reason is that such a system would produce open-ended budget deficits. That would not be much of a problem if the red ink lasted just a few years, but what if the need for large budget deficits did not go away? The Japanese Example Consider the case of Japan. Starting in the early 1990s, Japan’s private sector became a chronic net saver, as demand for credit evaporated amid savage deleveraging (Chart 7). In order to keep the economy from falling into a full-blown depression, the government started to run continual budget deficits. Effectively, the government had to soak up persistent private savings with its own dissavings. As a result, the debt-to-GDP ratio ballooned from 64% in 1991 to 237% by 2019 and is set to rise further this year. Many people predicted a debt crisis would engulf Japan. Takeshi Fujimaki, a former banker turned politician, has been forecasting a debt crisis for more than two decades.In 2010, financial pundit John Mauldin described Japan as a “bug in search of a windshield.” He reckoned that the country would “implode within the next two-to-three years,” with the yen falling to 300 against the dollar. Kyle Bass has made similarly dire predictions.1 How was Japan able to escape what seemed like certain doom? The answer is that the same factor that necessitated persistent budget deficits, namely excess private-sector savings, also allowed interest rates to fall. Despite a rising debt-to-GDP ratio, government interest payments have been trending lower over time (Chart 8). Today, the government actually earns more interest than it pays because two-thirds of all Japanese debt bears negative yields. Chart 7The Japanese Government Runs Persistent Budget Deficits Amid The Private Sector's Desire To Save Chart 8Japan: Ballooning Debt And Declining Interest Payments If anything, Japan erred in not easing fiscal policy by enough. Had Japan run even larger budget deficits, deflationary pressures would have been less acute, and as a result, real interest rates would have fallen even more than they actually did (Chart 9). Chart 9Japanese Real Yields Are Higher Than In Many Other Major Economies A Fiscal Free Lunch? The standard equation for public debt sustainability says that as long as the government’s borrowing rate is below the growth rate of the economy, the debt-to-GDP ratio will converge to a stable level no matter how large the fiscal deficit happens to be (See Box 1 for details). The caveat is that this “stable” debt-to-GDP ratio could turn out to be quite high. For example, if the government wants to run a primary budget deficit of 10% of GDP indefinitely, and GDP growth exceeds the real interest rate by two percentage points, the debt-to-GDP ratio will eventually converge to 500%. If interest rates were guaranteed to stay at zero forever, even a debt-to-GDP ratio of 500% would be no cause for alarm. But, of course, there is no such guarantee. For a country such as Italy, letting debt levels soar into the stratosphere would be highly risky. Countries that do not possess a central bank capable of acting as a lender of last resort could find themselves in a vicious spiral where rising bond yields raise the probability of default, leading to even higher bond yields (Chart 10). Chart 10Multiple Equilibria In The Debt Market Are Possible Without A Lender Of Last Resort For countries that do issue debt in their own currencies, default risk is less of a problem since their central banks can set short-term rates at any level they want and, if necessary, target long-term rates with yield curve control strategies. Nevertheless, even these countries would face difficult choices if the excess savings that permitted interest rates to stay low disappeared. A decline in national savings would raise the neutral rate of interest (the rate which equalizes aggregate demand with aggregate supply). If policy rates remained unchanged, the neutral rate of interest would end up being higher than policy rates, which would eventually cause the economy to overheat. At that point, policymakers would have two options: First, they could simply let the economy overheat such that inflation rises. If inflation is very low to begin with, modestly higher inflation would be welcome, as it would make the zero lower bound constraint less of a problem.2 Higher inflation would also speed up the pace of nominal income growth, leading to a lower debt-to-GDP ratio. That said, if inflation were to rise too much, it could have destabilizing effects on the economy. Second, they could tighten fiscal policy. A smaller budget deficit would add to national savings, while giving the government more resources to pay back debt. Tighter fiscal policy would also subtract from aggregate demand, thus reducing the neutral rate of interest. This would diminish the need for central banks to raise rates in the first place. Putting it all together, the optimal course of action, at least for countries that can issue debt in their own currencies, is to loosen fiscal policy until full employment has been restored and the central bank’s inflation target has been met. Once this has been achieved, the government should trim the budget deficit to keep inflation from getting out of hand. What Will Be Done Okay, so much for the idealized strategy. What will actually happen? As was the case following the Great Recession, there is a risk that some countries will tighten fiscal policy prematurely, causing the economic recovery from the pandemic to be slower than it would otherwise be. In the US, this is already happening. Federal emergency unemployment benefits under the CARES Act expired at the end of July; funding for the small business paycheck protection program has run out; and state and local governments are facing a severe cash crunch. BCA Research’s Geopolitical Strategy team, led by Matt Gertken, expects the logjam in Washington to be resolved in September. Most voters, including the majority of Republicans, want emergency unemployment benefits to be restored (Table 1). Additional fiscal stimulus would cushion the economy in the lead up to the November election, which would arguably benefit President Trump and the Republican party. Hence, there is a good chance that Congressional Republicans will accede to a fairly generous fiscal package. Table 1The Majority Continues To Support Expanded Unemployment Insurance Globally, the prevalence of negative real rates (and in some cases, negative nominal rates) should incentivize governments to run larger budget deficits than they have in the past. Increasing political populism will amplify this trend. Thus, despite some near-term hiccups, fiscal policy will remain highly stimulative. The Inflation End Game Chart 11The Ratio Of Workers-To-Consumers Is Now Falling What will happen when unemployment rates return to their pre-pandemic level in three or four years? Will governments tighten fiscal policy to prevent overheating or will they let inflation run loose? Our guess is that they will let inflation rise. National savings can shrink either because the private sector is spending more or because the private sector is earning less. Looking out beyond the next few years, the latter is more likely than the former. This is because the ratio of workers-to-consumers globally will decline sharply over the coming decade as more baby boomers exit the labor force (Chart 11). Spending will decelerate, but output and income will decelerate even more by virtue of this demographic reality. It is difficult to boost tax revenue in an environment of slowing real income growth. If output falls in relation to spending, inflation will rise. At least initially, central banks will welcome the burst of inflation. They have been trying to push up inflation for years. Past inflation undershoots will be used to justify future inflation overshoots, a doctrine the Fed officially blessed at the virtual Jackson Hole symposium last week. Other central banks will be loath to raise rates if the Fed stands pat for fear that their own currencies will surge against the US dollar. The end result is that inflation will increase, first in the US and then everywhere else. A quick glance at long-term inflation expectations suggests that markets do not discount this risk at all (Chart 12). What does all this mean for investors? For the next few years, the combination of ample fiscal stimulus and easy monetary policy will foster a supportive backdrop for global equities. Despite the rally in stocks since March, the global equity risk premium remains quite elevated, especially outside the US (Chart 13). Investors should remain overweight global stocks versus bonds on a 12-month horizon. Chart 12Investors Believe Inflation Will Stay Muted In The Long Term Chart 13Non-US Stocks Look Cheaper Than Their US Peers In Both Absolute Terms And In Relation To Bond Yields Looking further out, the secular bull market in equities will end only when central banks are forced to scramble to contain inflation. Fortunately, that day of reckoning is at least a few years away.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1 Ben McLannahan, “Japanese Bonds Defy the Debt Doomsters,” Financial Times, dated August 8, 2012; Mariko Ishikawa, Kenneth Kohn and Yumi Ikeda, “Soros Adviser Turned Lawmaker Sees Crisis by 2020,” Bloomberg News, dated September 27, 2013; and Dan McCrum, “Kyle Bass bets on full-blown Japan crisis,” Financial Times, May 21, 2013. 2 For example, if inflation is 3%, a central bank could produce a real rate of -3% by bringing policy rates down to zero. In contrast, if inflation is only 1%, the lowest that real rates could fall is -1%, which may not be stimulative enough for the economy.   Box 1The Arithmetic Of Debt Sustainability   Global Investment Strategy View Matrix Current MacroQuant Model Scores

Highlights The dollar has entered a structural bear market but is at risk of a countertrend bounce.  The catalyst for such a bounce will be the underperformance of G10 economies, specifically the euro area relative to the US. The immediate trigger is a renewed surge in infections in the euro area. Eventually, in a post-COVID-19 world, the structural growth rate of the euro area should improve relative to the US. The Federal Reserve’s resolve to allow for an inflation overshoot will amplify the global supply of dollars. This will lead to a self-reinforcing spiral of better global growth, and a weaker dollar. Emerging market currencies have underperformed the drop in the dollar but will play catch up. We continue to recommend a three-pronged strategy for playing dollar shorts: Hold Scandinavian currencies, precious metals (especially silver and platinum), and the Japanese yen as insurance. We were stopped out of our tactical short GBP position. Stand aside for now. Our FX model remains dollar bearish and is recommending shorting the DXY for the month of September. Feature August is seasonally a strong month for the dollar (and other safe-haven currencies, for that matter), but this year bucked that trend. Despite the DXY index punching below key support levels since the March highs and becoming very oversold, the downtrend continued in August unabated. Technically, it suggests that the forces against the US dollar are quite powerful. Our trade basket has benefitted tremendously from the drop in the dollar this year, and we continue to advocate short dollar positions over a 12-month horizon. That said, we had tried playing a tactical bounce in the DXY via a short GBP position last month and got stopped out. September remains a seasonally weak month for the pound, but the dollar also tends to be weak against most other procyclical currencies (Chart I-1). As such, our bias is that while the dollar is due for a countertrend bounce, it might not be a playable one. Technical indicators also suggest that the dollar is likely to consolidate losses in the weeks ahead.  Technical indicators also suggest that the dollar is likely to consolidate losses in the weeks ahead. Our intermediate-term indicator is oversold, and speculators are quite short the cross (Chart I-2). However, any bounce should be used as an opportunity to establish fresh short positions, as the DXY is likely to punch below 90 by year end. Chart I-1September Is A Good Month For Dollar Shorts Chart I-2Rising Number Of ##br##Dollar Bears What Are The Catalysts For A Countertrend Bounce? While the dollar has entered a structural bear market, two catalysts are lining up which could trigger a countertrend bounce: The Eurozone, which was well into its reopening phase, has been hit hard by a second wave of COVID-19. Meanwhile, new infections in the US have started to flatten out (Chart I-3). As a result, economic momentum, which was higher outside the US, has rolled over. Improving relative economic performance between the US and other G10 countries could be a key catalyst behind dollar strength (Chart I-4). It is true that the number of new deaths in both France and Spain remain low compared to the surge in the number of new cases. But, while it might ease draconian government lockdowns, citizens are likely to have concerns and may pay heed to the potential of being infected (and dying). This could slow economic activity. Chart I-3US Cases Are ##br##Flattening Chart I-4Economic Momentum Rolling Over Outside The US The US stock market is overstretched and is at risk of a more significant correction in the near term, which could introduce some volatility in global bourses and buffet the dollar. The fall in the DXY has been a mirror image of the rise in the S&P 500 (Chart I-5). Renewed geopolitical tensions between China and the US as well as the upcoming US presidential election are sources of risk, and a catalyst to hedge short positions. Historically, the dollar has tended to rise with both increasing equity and geopolitical risk premia. This is the benefit of being a reserve currency. Chart I-5The Dollar & S&P 500 In a nutshell, the US economy had been relatively weak compared to the rest of the world. Tentative August data is showing that this trend may now be reversing. While one cannot use one data point to extrapolate a trend, it is worth monitoring. What Does The Federal Reserve Shift Mean For The Dollar? Beyond a countertrend rally, the balance of forces are still stacked against the US dollar. The Fed’s pivot to target average inflation will only accentuate these forces. In a special report this week, our fixed income strategists outlined the major takeaways from the Fed’s policy shift.1 In a nutshell, the Fed will now allow for an inflation overshoot on a going-forward basis. Part of the reason the US dollar outperformed from 2011 on was because economic growth was relatively better, which allowed interest rates to be higher. With economic growth in the US held hostage by the pandemic, the Fed has been forced to drop rates to zero, effectively wiping out the nominal US interest rate advantage (Chart I-6). The fall in the DXY has been a mirror image of the rise in the S&P 500. Going forward, we know two things. First, the Fed (or any other central bank for that matter) will not raise rates anytime soon. But more importantly, the Fed has telegraphed that they will allow for an inflation overshoot. This means that real rates in the US are bound to become even more negative. It is impressive that countries like Switzerland and Japan, with negative policy rates, have much higher real rates than the US today (Chart I-7). This does not bode well for the dollar. Chart I-6Interest Rates In The US Have Collapsed Chart I-7Real Yields Could Be Lowest In The US Has The Euro Rallied Too Fast? The rise in the euro has certainly stirred discussion among policymakers and investors, with some commentators pointing to some measures of the trade-weighted currency being near record highs. While the euro certainly has scope to correct towards the 1.15-1.16 level, this should be used to accumulate long positions. In our view, there is little indication that currency strength is becoming a headwind for the economy. Indeed: The euro area continues to sport a very healthy trade and current account surplus, a sign that the euro remains very competitive among its trading partners (Chart I-8). This is remarkable in a world of slowing global trade. Correspondingly, the euro still remains 12% undervalued against our fair value purchasing power parity (PPP) models (Chart I-9) Chart I-8Is This An Expensive Currency? Chart I-9The Euro Is Cheap Much ink is being spilled over the fact that headline inflation in the euro area fell below zero for the first time since 2016. Quickly forgotten is that a fall in inflation actually increases the fair value of the currency in a PPP framework. It also makes European goods more competitive. In the long term, that could be the difference between whether foreigners buy Cadillacs or BMWs. The structural appreciation in the trade-weighted Swiss franc is a case in point. As intra-European trade represents a large share of cross-border transactions, currency considerations become more of a moot point. In 2019, most member states had a share of intra-EU exports of between 50% and 75% (Chart I-10). Chart I-10Europe Exports A Lot To Europe Going forward, an agreement on the mutualization of European debt means we can begin to expect more synchronized business cycles as fiscal stabilizers kick in.2  The reality is much more complicated, of course, but the biggest roadblock to mutualized debt (which is that it could never happen) has been toppled. This will allow the neutral rate of interest in the euro area to head higher (Chart I-11). The reason is that both fiscal and monetary policy can now be synchronized across member states: Chart I-11Can Euro Area Growth Accelerate? The European Central Bank and European Commission have successfully lowered the cost of capital in the euro area, probably well below the return on capital. With Italian and Spanish bond yields now collapsing towards those in the core, liquidity is flowing to where it is most needed, significantly curtailing euro break-up risk. Social distancing might remain in place for a while, meaning services will suffer more than manufacturing. More importantly, a huge proportion of the service sectors in the euro area is tied to tourism (Chart I-12), while it remains domestic in places like the US. So, as the tourism season wanes and we get into the winter months where social distancing is all the more important, the underlying trend growth in manufacturing could be higher. A more drawn-out services recovery raises the prospect that countries geared more towards manufacturing such as Europe, Japan and China, could experience better growth (Chart I-13). Chart I-12Tourism Is Important For Europe Chart I-13Higher Service Share In The US This will occur at a time when European equities, especially those in the periphery, are very cheap. Part of the reason is that most Eurozone bourses are heavy in cyclical stocks that are well into a 10-year relative bear market.3 A re-rating of cyclical stocks, especially banks and energy, relative to defensives could be the catalyst that carries the next leg of the euro rally. This could push the EUR/USD towards 1.25. Does Abe’s Resignation Change The Yen’s Outlook? Chart I-14More Jobs, More Savings Japanese Prime Minister Shinzo Abe’s health has pushed him to resign from office. The front runner from the Liberal Democratic Party (LDP), Yoshihide Suga, is likely to be his successor. Suga-san has publicly said he would like to continue with “Abenomics” and even enhance it. As such, the status-quo is more likely than a draconian policy change, as argued by our geopolitical colleagues.4 That said, there is a narrative floating around that he could be more of a fiscal hawk. Our belief is that economic forces are usually more powerful than political ones over the long term. And the economic force holding Japan hostage right now is the real threat of a deflationary spiral, which will send the yen higher and lead into a negative self-reinforcing feedback loop. Japanese companies certainly do not appreciate an excessively stronger yen, due to negative translation effects on profits. And neither does the Japanese government, since it is deflationary, and high government debt levels cannot be inflated away. With Japan having one of the highest real rates in the G10 right now, Suga-san’s more moderate fiscal stance might be overcome by a powerful deflationary wave in Japan. It is remarkable that while Japan had been able to keep a lid on the pandemic, it did see a short resurgence of new cases. That has since subsided, but it remains a clear reminder to the public that going out to spend money is risky business. As a result, the worker’s saving ratio continues to surge as unemployment rises and consumer confidence drops (Chart I-14). This is a trend any politician will find very difficult to ignore. As Suga-san stumbles to establish his stance, the yen could rise. Emerging market (EM) currencies such as the BRL, ZAR, INR, or even until recently the CNY, have lagged behind the drop in the DXY index. As we outlined in our weekly report in June, we remain yen bulls.5 This view rests on three pillars. First, Japan has one of the highest real rates in the G10, meaning outflows from Japanese fixed income investors will fall. Second, the yen is very cheap relative to the US dollar. And finally, during dollar bear markets, the yen more often than not outperforms the USD. This suggests holding a long yen position is a “heads I win, tails I do not lose much” proposition. EM Currencies Have Underperformed, Why? A lot of skepticism on the dollar rally has centered on the fact that emerging market (EM) currencies such as the BRL, ZAR, INR, or even until recently the CNY, have lagged behind the drop in the DXY index (Chart I-15). While this has been a historically rare event, so has the pandemic. As a result, we have witnessed a few economic shifts: Chart I-15EM Currencies Are Lagging Since 2014-2015, central banks have been aggressively trying to diversify out of dollar reserves. Unfortunately for most currencies, their alternative has been other safe-haven assets such as gold and the yen. IMF reserve data show that both the yen and gold have borne the brunt of dollar diversification. This trend has been supercharged in 2020, with the addition of the euro (Chart I-16). To put this in perspective, Russia now over 24% of its FX reserves in gold versus under 3% in 2008. Russia has very little dollar reserves. China has risen from less than half a percentage point of gold reserves in 2008 to over 3%. Imagine if China were to shift half of its gargantuan Treasury holdings into alternative assets? The perfect “robust” portfolio in simple terms has been a 60/40 one: 60% in equities, 40% in bonds. This has delivered low volatility and exceptional returns. But with government fixed income rates near zero, managers are now looking for alternatives. Gold and precious metals look like a perfect candidate in a world where central banks want to asymmetrically generate inflation (Chart I-17). Chart I-16Diversification Out Of Dollars Into Gold Chart I-17Would You Bet On US Bonds Or Gold At Zero Rates?     The pandemic raged in a lot of EM countries while it was falling in DM. This has weakened EM fundamentals relative to their developed-market peers. The EM Markit PMI index has been falling sharply relative to that in the US, a sea-change from what we saw earlier this year (Chart I-18). As a result, many EM central banks have aggressively cut rates, narrowing interest rate differentials with the US. In their latest report, our emerging market colleagues contend that EM fundamentals remain poor, but could improve Chart I-18EM Relative Growth Relapsing EM currencies have a lot going for them. First, some are extremely cheap by historical standards. This should greatly help ease financial conditions. Second, our technical indicator shows that the dollar decline is becoming a lot more broad-based at the margin (Chart I-19). The percentage of countries with rising exchange rates versus the dollar has surged. Within EM, we continue to favor precious metal producers (in line with our BCA Research bullish precious metals view) and oil producers, versus a basket of oil consumers. Chart I-19Dollar Drawdown More Widespread The Message From Our Trading Model Our FX trading model remains bearish on the US dollar for the month of September. It has upgraded Australia and Norway, while downgrading New Zealand (Chart I-20). The white paper for the model can be found here. Chart I-20AModel Recommendations For September Chart I-20BModel Recommendations For September Our bias, however, is that the dollar is due for a tactical bounce. We tried to implement this via a short GBP position but were thrown offside. So far, the UK PMI continues to outperform both that of the US and the euro area, suggesting the UK economy has been relatively more resilient to the pandemic. As such, we prefer to tighten stops on our profitable trades as a way to manage risk.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see US Bond Strategy and Global Fixed Income Strategy Special Report, "A New Dawn For US Monetary Policy", dated September 1, 2020. 2 Please see Foreign Exchange Strategy Weekly Report, "EUR/USD And The Neutral Rate Of Interest", dated June 14, 2019. 3 Please see Foreign Exchange Strategy Special Report, "Currencies And The Value-Vs Growth Debate", dated July 10, 2020. 4 Please see Geopolitical Strategy Weekly Report, "Abenomics Will Smell As Sweet By Any Other Name", dated September 4, 2020. 5 Please see Foreign Exchange Strategy Weekly Report, "An Update On The Yen", dated June 12, 2020. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US has been solid: The Markit manufacturing PMI rose from 50.9 to 53.1 in August. The ISM manufacturing PMI also climbed from 54.2 to 56, expanding for a fourth straight month. Notably, the ISM new orders index soared from 61.5 to 67.6. The goods trade deficit widened to $79.32 billion from $70.99 billion in July. Initial jobless claims decreased to 881K for the week ending August 28th. The DXY index recovered by 1% this week, supported by promising PMI releases. In the long run however, our bias is that the USD might be on the verge of a long bear market. Diminished advantage of interest rate differentials, higher twin deficits and negative sentiment all point to a lower dollar going forward. Report Links: A Simple Framework For Currencies - July 17, 2020 DXY: False Breakdown Or Cyclical Bear Market? - June 5, 2020 Cycles And The US Dollar - May 15, 2020 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been negative: The Markit manufacturing PMI remained flat at 51.7 in August while the services PMI fell from 54 to 50.5. Headline consumer price inflation fell from 0.4% to -0.2% year-on-year in August. Headline inflation sank from 1.2% to 0.4%. Moreover, producer prices decreased by 3.3% year-on-year in July. The unemployment rate ticked up from 7.7% to 7.9% in July. The euro fell by 1.2% against the US dollar this week. The negative inflation rate raises questions about ECB’s baseline inflation scenario and inflation forecasts, putting more pressure on the ECB to adopt a more dovish stance ahead of the monetary policy meeting next week.  Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been mostly negative: The manufacturing PMI increased from 45.2 to 47.2 in August, while the services PMI slipped to 45 from 45.4. Retail trade fell by 2.8% year-on-year in July, following a 1.3% decline the previous month. Moreover, industrial production plunged by 16.1% year-on-year in July after an 18.2% decrease in June.  Construction orders fell by 22.9% year-on-year in July. Housing starts also plunged by 11.4%. The jobs-to-applicants ratio fell from 1.11 to 1.08 in July. The unemployment rate increased from 2.8% to 2.9%. The Japanese yen remained flat against the US dollar this week. We continue to favor the Japanese yen as fears grow for a second wave of COVID-19. Moreover, Japan now sports the second highest real interest rates in the G10 universe. Report Links: The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the UK have been positive: The manufacturing PMI rose to a 30-month high of 55.2 in August from 53.3 in July. The services PMI also increased to 58.8 from 56.5 the previous month. Mortgage approvals increased by 66.3K in July, up from 39.9K in June. Housing prices grew by 3.7% year-on-year in August. The British pound appreciated by 0.9% against the US dollar this week. While the latest PMI release showed fast expansion in the manufacturing sector for the month of August, the employment outlook remained unfavorable. Moreover, COVID-19 and Brexit uncertainties remain headwinds for the British pound. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 United Kingdom: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been mostly negative: GDP slumped by 7% quarter-on-quarter in Q2, the worst figure on record, confirming the nation’s first recession in almost 30 years. The commonwealth manufacturing PMI increased from 48.8 to 49.4 in August. Exports tumbled by 4% month-on-month while imports surged by 7% monthly in July. The trade surplus shrank by A$3.6 billion to A$4.6 billion. Building permits increased by 6.3% year-on-year in July, following a 15.8% contraction the previous month. AUD/USD fell by 1.6% this week. The RBA left its interest rate unchanged at 0.25% on Tuesday. However, it has increased the size of the term funding facility and extended the banks’ access to low-cost funding through the end of June 2021. Report Links: On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand has been mixed: The ANZ business confidence index increased marginally from -42.4 to -41.8 in August, while the activity outlook index slipped from -17 to -17.5. Building permits fell by 4.5% month-on-month in July. The goods terms of trade index rose by 2.5% quarter-on-quarter in Q2. The New Zealand dollar depreciated by 0.7% against the US dollar this week. In the Wellington speech this Wednesday, RBNZ Governor Adrian Orr said that “We strongly believe that the best contribution we can make to our monetary and financial stability mandates is ensuring we head off unnecessarily low inflation or deflation, and high and persistent unemployment”, suggesting a more dovish stance in the coming monetary policy reviews. Report Links: Currencies And The Value-Versus-Growth Debate - July 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada has been mostly negative: Annualized GDP slumped by 38.7% quarter-on-quarter in Q2.  The manufacturing PMI rose to 55.1 in August from 52.9 the previous month. Building permits fell by 3% month-on-month in July. Exports rose to C$45.4 billion from C$40.9 billion in July. Imports also increased to C$47.9 billion from C$42.5 billion. The trade deficit widened by C$0.9 billion to C$2.5 billion. The Canadian dollar depreciated by 0.6% against the US dollar this week. The contraction in Q2 GDP is more than twice as bad as the lowest point reached during the GFC. On the positive side, the June monthly GDP increase of 6.5%, compared with the previous month, is showing signs of recovery with the easing of COVID-19 restrictions at the end of Q2. Report Links: Currencies And The Value-Versus-Growth Debate - July 10, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been mixed: The KOF leading indicator surged from 86 to 110.2 in August. Real retail sales increased by 4.1% year-on-year in July. The manufacturing PMI increased from 49.2 to 51.8 in August. Headline consumer prices remained in deflation territory at -0.9% year-on-year in August. The Swiss franc remained flat against the US dollar this week. The SNB Governing Board Member Andrea Maechler said on Tuesday that negative interest rates are “extremely important” for Switzerland. Being deeply in deflation for seven consecutive months, Switzerland now sports the highest real rate in G10.   Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway have been negative: The current account surplus narrowed to NOK 20.5 billion in Q2 from NOK 27 billion in the same quarter last year, the smallest surplus since the fourth quarter of 2017. The Norwegian krone depreciated by 2.2% against the US dollar this week, making it the worst-performing G10 currency. That said, we remain positive on the Norwegian krone. Our FX model indicator for the NOK increased from 1 to 2 for the month of September, signaling a strong buy for the currency and pushing the sentiment component up from neutral to long. Report Links: A New Paradigm For Petrocurrencies - April 10, 2020 Building A Protector Currency Portfolio - February 7, 2020 On Oil, Growth And The Dollar -  January 10, 2020 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been mixed: GDP fell by 7.7% year-on-year in Q2, or 8.3% quarter-on-quarter, the steepest contraction on record. The manufacturing PMI increased from 51.4 to 53.4 in August, the fourth consecutive month of manufacturing expansion. The new orders index surged from 52.2 to 56. The Swedish krona fell by 1.1% against the US dollar this week. As one of the most pro-cyclical currencies, the Swedish krona will benefit the most from the global business cycle recovery. Moreover, the SEK is still trading at a tremendous discount against its fair value, as compared to the US dollar. We continue to overweight the Nordic basket to both USD and EUR but are tightening the stop loss this week amidst potential market volatilities. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades