US Dollar
Highlights There are a few consistencies with the dollar breakout. Global growth is peaking and the risk of a significant slowdown early next year has risen. As a momentum currency, further gains in the DXY remain very high in the near term. We are shifting our near-term target to 98 (previously 95). That said, the dollar is now close to pricing a global recession, which seems improbable given easy monetary settings and ample fiscal stimulus. High inflation is not a US-centric phenomenon but a global problem. This means that monetary policy in the US cannot sustainably diverge from other central banks. Correspondingly, low US TIPS yields do not confirm the breakout in the dollar. Even if the US 10-year Treasury yield rises towards 2.5%, real interest rates will remain very low compared to history and other G10 economies. While global growth will slow next year, we expect that it will remain robust. And if it rotates from the US to other countries, the dollar will have a very sharp reversal. Our strategy is to stick with trades at the crosses rather than outright dollar bets. These include long AUD/NZD, long CHF/NZD, long EUR/GBP and long a petrocurrency basket versus the euro. Once the majority of our technical indicators start to flag a reversal, we would be sellers of the DXY and buyers of EUR/USD. Feature Chart I-1The Dollar Diverges From Real Rates After spending most of this year range bound between 89 and 94, the DXY index has broken out. The narrative has been centered around rising US inflation, which will trigger much faster interest rate increases from the Fed. This is consistent with recent economic data, where US inflation has indeed blown out, and is also rising at the fastest pace among G10 countries. What has been inconsistent is that US TIPS yields remain very low, and have diverged from the broad dollar trend (Chart I-1). One of the key structural drivers of currencies is real interest rate differentials. If the Fed does move ahead of the inflation curve and aggressively hikes interest rates, then US TIPS yields will rise and catch up with the dollar. Otherwise, the recent rise in the greenback could represent a capitulation phase that will quickly reverse should the inflationary mania subside. Consistencies With The Dollar Rise The market is now pricing in that the Fed will raise interest rates much faster, compared to earlier this year. According to the overnight index swap (OIS) curve, the Fed is now expected to lift rates at least twice by December 2022, compared to earlier this year (Chart I-2). Meanwhile, market pricing is even more aggressive when looking at the December 2022 Eurodollar contract, relative to either the Euribor contract (European equivalent) or Tibor (Japanese equivalent). The market suggests that compared to earlier this year, a 63bps spread difference is now warranted between US and European interest rates, while an 80bps difference is appropriate vis-à-vis Japanese rates. This shift perfectly explains the move in the dollar over the last few weeks (Chart I-3). Chart I-2Markets Now Expect A More Hawkish Fed Chart I-3A Key Driver Of The Dollar Rally These market moves have been consistent with economic developments. Upside economic surprises in the US have dominated other G10 economies and supported the dollar (Chart I-4). The slowdown in China has been another hiccup in the global growth story. While global export growth has remained relatively resilient, the narrative is that the slowdown in Chinese demand is metastasizing into a genuine slump that will impact commodity import demand and hurt procyclical currencies liked the AUD (Chart I-5). Chart I-4Positive Economic Surprises Have Supported A Strong USD Chart I-5A Slowing China Has Hurt Currencies Like The AUD The slowdown is not unique to China. With new Covid-19 infections surging in various European countries, ex-US economic data is likely to remain underwhelming early next year. Within this context, the US economy remains relatively immune. Exports explain only 10% of US GDP. The IMF projects that the US is one of the first countries to close its output gap (Chart I-6). This will support a tighter monetary stance in the US, compared to other G10 countries. Contradictions With The Dollar Rally There are a few contradictions with the dollar rally. First, the Fed is already lagging the US inflation curve. Various DM and EM central banks have calibrated monetary policy higher in response to rising inflation (Chart I-7). While the Fed might accelerate the pace of tapering asset purchases, other central banks in developed economies have already ended QE and are raising rates. At some point, relative monetary policies would matter for currencies, as has historically been the case. Since the start of the year, market pricing for higher rates according to the OIS curve has been lifted for most G10 countries (Table 1). Yet the dollar has rallied, while other currencies have collapsed (Chart I-8). Chart I-7Many Central Banks Are Already Hiking Interest Rates Chart I-8Will The Fed Hike As Much As Is Priced By The Dollar? Second, part of that rally has been driven by speculative inflows, and not by underlying economic fundamentals. Net speculative positions in the US dollar are near levels that have usually signaled that the trade is becoming much crowded (Chart I-9). As we highlighted in Chart 1, this has occurred amidst very low nominal and real interest rates. But more importantly, as a reserve currency, the dollar enjoys the priviledge of being the safe-haven asset of choice. It is quite plausible that one of the key drivers of the rally has also been hedging by fund managers for an equity market correction (Chart I-10). Chart I-9Speculators Are Nearing Exhaustion ##br##Levels Chart I-10Long Dollar Is Being Used To Hedge Bullish Equity Bets Third, inflation could indeed prove to be transitory. Our sister publication, the Commodity & Energy Strategy, suggests that metals and oil prices will remain well bid in the near term. Inflation however is about rates of change. Natural gas prices rose 100% this year while oil prices rose 60%. Market expectations are that these prices will roll over (Chart I-11). The Baltic Dry Index, a proxy for shipping costs and supply bottlenecks, initially rose 300% and is now down 53% from its peak. A middle ground where prices remain well bid but do not generate the same inflationary impulse next year seems most plausible. This will ease all market expectations for central bank hawkishness, but could sound the death knell for the dollar that has quickly moved to price in the current market narrative. Chart I-11Some' Inflation Will Be Transitory Fourth, a strong US dollar hurts US growth. According to the Fed’s own estimates, a 10% rise in the dollar reduces US growth by 0.5% in the subsequent four quarters and 1.2% over two years. Meanwhile, a strong US dollar will certainly alleviate pressure on the Fed to fight inflation. A Counterpoint View To The Market Narrative Covid-19 will be with us for a while. As such, the volatility of growth forecasts around infection waves will subside. The remarkable thing is that despite fears of a global growth slowdown, there is a pretty robust expectation that the US will fare poorly relative to other developed markets in terms of growth next year. Countries such as Canada, New Zealand, the UK, and Japan are seeing a bottoming in growth momentum relative to the US (Chart I-12). For some, this is occurring at the same time as their local central banks are becoming more orthodox about monetary policy. As we have argued earlier, this is clear real-time evidence that the Fed will lag the inflation curve. Chart I-12AA Global Growth Rebound Outside The US Chart I-12BA Global Growth Rebound Outside The US One key signpost is China. It has tightened policy amidst very low inflation, and the traditional relationship between real rates and the RMB is working like a charm as the currency appreciates in trade-weighted terms. In a nutshell, currency markets tend to reconverge with real interest rate differentials over time. This will eventually be the case with the dollar (Chart I-13). Chart I-13Real Interest Rates Eventually Matter For Currencies Finally, China might marginally ease policy to sustain growth. In our view, China could stand pat since nominal bond yields are falling and exports are robust suggesting overall financing conditions are not a problem. But if this is a primate cause for fuelling long dollar bets, that will eventually hurt EM demand, China could also shift. This will be bullish for the dollar in the near term (it will require a riot point for China to shift), but bearish the dollar over a cyclical investment horizon, as commodity economies bottom. Investment Strategy Chart I-14Current Dollar Strength Is Pricing In A Manufacturing Recession In the current environment, the DXY could hit 98. This will be consistent with a blowout in our capitulation index, as well an exhaustion of dollar bulls. That said, the dollar is now close to pricing a global manufacturing recession, which seems improbable given easy monetary settings and ample fiscal stimulus in most DM economies (Chart I-14). Our strategy is to stick with trades at the crosses rather than outright dollar bets. These include long AUD/NZD, long CHF/NZD, long EUR/GBP and long a petrocurrency basket versus the euro. Once the majority of our technical indicators start to flag a reversal, we would be sellers of the DXY and buyers of EUR/USD. Finally, our agnostic trading model continues to suggest short dollar positions (Chart I-15). Admittedly, it is the valuation component driving the calibration, rather than sentiment or appreciation for the investment shift in the macro narrative. In our portfolio, we will sit on the sidelines until most of our intermediate-term indicators stage a reversal. Chart I-15AOur Model Is Short The Dollar, But Stand Aside For Now Chart I-15BOur Model Is Short The Dollar, But Stand Aside For Now Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary
Dear Client, Next week, we will be sending you BCA Research’s Annual Outlook, featuring long-time BCA client Mr. X, who visits towards the end of each year to discuss the economic, financial and commodity market outlook for the year ahead. All the best, Bob Ryan Chief Commodity & Energy Strategist Highlights Local politics in Chile and Peru will become critical to the global energy transition, particularly as regards the supply side of the most critical metal for this transition: copper. Chile's runoff elections next month will pit a former congressman portrayed as a hard-right candidate against a protest leader-turned-legislator in a battle for the presidency of a country that accounts for ~ 30% of global copper mining output. In Peru, which accounts for just over 10% of global copper production, the left-of-center administration indicated it will mediate talks to close two gold and silver mines, despite protests from its corporate owners. Tightly balanced supply-demand fundamentals will keep inventories of refined copper extremely low, which will slow the early-stage global transition to renewable power generation until these stocks can be replenished (Chart of the Week). Chinese copper smelters reportedly are collaborating to move refined metal to LME-approved warehouses to restock depleted inventories. While this could reduce backwardations in futures markets, it has not overly depressed flat-price levels, which are within ~ 7% of all-time highs of $4.78/lb ($10,533/MT) put up in May. Fundamentally, base metals – especially copper and aluminum – will remain tight, which supports our long positions in the S&P GSCI and the COMT ETF. Feature Despite a marked deceleration of growth in China brought on by fuel and power shortages, and a strong USD creating tighter financial conditions globally, copper prices – and base metals generally – remain well supported, even as speculative interest, for the most part, has waned this year (Chart 2). Chart of the WeekTight Copper Inventories Support Prices, Backwardation Chart 2Specs Back The Truck Up For Copper Spec Interest Wanes Copper and the other metals are well bid because of tight fundamentals – the level of demand has been and remains above the level of supply globally (Chart3). This will continue to exert pressure on inventories and force a re-shuffling of stocks globally – likely from China bonded warehouses to the LME (Chart 4). The London Metal Exchange (LME) was forced to take extraordinary measures to maintain orderly markets and has prompted Chinese smelters to collaborate on shifting material to LME sheds in Asia.1 However, much more refined copper will have to be shipped to these sheds to keep markets from launching into another steep backwardation on the LME similar to last month's $1,100/MT first-to-third-month spread last month – an indication of desperation on the buy side. Chart 3Low Copper Stocks Will Persist That said, if the only thing that improves LME stocks is a re-shuffle from existing inventories, the net position of the world will largely remain unchanged over time. Demand will be met with inventory draw-downs, but supply will not have increased, which, at the end of the day, means markets will continue to tighten. Chart 4Globally, Exchange Warehouses Tighten Chile, Peru Politics Become Fundamental Geopolitics always is at the heart of commodity markets: Who's in power and the agendas being pursued matter so much, because, in many cases, unrefined exports of raw commodities sustain governments and important elements of economies in many states. This is becoming clear in Chile and Peru, two states with contestable elections, where the outcomes can profoundly affect the supply side of global fundamentals. Earlier this year, it looked like Chile's presidential and congressional elections would favor left-of-center candidates who did not campaign on market-oriented policies. National elections this past weekend resulted in a run-off that will be held 19 December, as neither the left- nor right-of-center candidates polled an absolute majority. Right-of-center candidates also polled unexpectedly well in congressional elections. This likely translates into something resembling the divided government in the US, which means neither side will be able to get all it wants through the legislature. In the lead-up to the Constitutional re-write expected following elections, the agendas of the left and right are markedly opposed. On the left, greater government involvement in the resources sector has been part of the campaigning, while on the right increased private investment in the stated-owned Codelco, the largest copper producer in the world, is advocated. Both sides also disagree on changes in taxes and royalties, which obviously is of great concern to investors and copper-market participants.2 Chile also is a world-class supplier of lithium, zinc, gold, silver and lead, so it's not just copper markets following developments there with concern. In Peru, the country's newly sworn-in prime minister said she is willing to broker talks on shutting down gold and silver mines in communities where residents have been protesting as soon as possible. This drew a heated reply from mining interests immediately. Peru is the second largest copper miner in the world behind Chile, and the treatment of the owner of the disputed gold and silver mines, Hochschild Mining, is being followed closely. Base and precious metals markets are being forced to factor in a new set of political dynamics, as local political tensions spill into the supply side, causing overall political uncertainty in critical mining states to increase. This will restrain investment, which bodes ill for the global renewable- energy transition. Copper Defies Stronger USD Despite a stronger-than-expected USD this year – boosted most recently by the re-appointment of Jay Powell as Fed Chair and the elevation of Lael Brainard as Vice Chair – copper and base metals have held up well.3 Generally, a strong dollar is bearish for base metals prices (Chart 5), and copper especially (Chart 6). A stronger USD tightens global financial conditions, which, not unexpectedly, is bearish for copper; however, as Chart 7 shows, this effect also has been overcome by the tight copper fundamentals globally.4 We remain bearish the USD going into next year, in line with our colleagues at BCA's Foreign Exchange Strategy. Massive fiscal stimulus in the US in particular, along with continued monetary accommodation from the Fed to fund the deficits this will produce, is expected to weaken the dollar and boost trade. Chart 5Base Metals Defy Strong USD Chart 6Copper Defies USD Strength, Boosted By Cyclicals Performance Chart 7Copper Overcomes Tighter Global Financial Conditions In a recent simulation, we show a 10% fall in the USD and a 5% pick-up in EM imports, along with continued strong performance from cyclicals would lift copper prices to $5.30/lb on the CME Comex by year-end 2022, in our estimation (Chart 8). Chart 8Weaker USD, Stronger EM Imports, Cyclical Strength Would Booster Copper. Investment Implications Base metals markets, particularly copper, have withstood tightening financial conditions brought on by a strong USD, a sharp slowdown in Chinese growth brought on by an energy shortage and rising interest rates. This is largely due to extremely tight supply-demand fundamentals, which continue to keep global inventories under pressure. Copper, metals generally, and precious metals also will get a lift from local political tensions spilling into the supply side of markets as overall political uncertainty in critical mining states restrains investment. We remain long the S&P GSCI and the COMT ETF, anticipating higher copper prices and a return to steeper backwardation. Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com Commodities Round-Up Energy: Bullish Oil markets looked right through the announcement the US will tap its Strategic Petroleum Reserve (SPR) for 50mm barrels beginning next month, rallying 3.3% to $82.31/bbl by Tuesday's close following the announcement (Chart 9). Under a Congressionally mandated release, the 18mm barrels already authorized had been factored into market balances. The incremental 32mm barrels of crude oil being supplied to the market will be released to successful bidders between 16Dec21 and 30Apr22. These volumes will be repaid during US fiscal years 2022-24, with a volumetric premium added to the initial volume lifted by the successful bidders, which will be specified in the terms of the crude-oil loan. The US fiscal year begins on 1 October. The longer it takes to return the crude oil back to the SPR, the higher the premium volume of crude oil will be required, per the SPR's terms and conditions. The Biden administration succeeded in persuading the governments of China, India, Japan, South Korea and the UK to release unspecified volumes from their SPRs as well. Although volume commitments and release dates were not included in the press release from the White House some 20mm to 30mm barrels reportedly could be supplied from these SPRs. Precious Metals: Bullish Gold prices fell violently, and the US dollar rose following Jay Powell’s re-nomination to Fed chair (Chart 10). Markets assume the Fed will stay the course on its current monetary policy, as opposed to loosening further, which would have lifted gold prices on the back of higher inflation expectations. We believe interest rate hikes will not be brought forward unless inflation expectations become unhinged. In the short run, however, high fuel prices and logistical bottlenecks will continue to feed into higher inflation, implying the Fed will remain behind the curve. Both Powell and Lael Brainard, who was nominated as vice chair of the Fed, stressed vigilance against inflation. In his statement following Biden's decision to re-appoint him as Fed Chair, Powell noted: "Today, the economy is expanding at its fastest pace in many years, carrying the promise of a return to maximum employment. … We know that high inflation takes a toll on families, especially those less able to meet the higher costs of essentials like food, housing, and transportation. We will use our tools both to support the economy and a strong labor market, and to prevent higher inflation from becoming entrenched." Brainard's remarks struck a similar tone. Chart 9 Chart 10 Footnotes 1 Please see Column: All eyes on China as LME copper spreads collapse: Andy Home, published by reuters.com 18 November 2021. 2 Please see Chile elections may impact a third of the world’s copper supply, published by mining.com on November 19, 2021. 3 Please see Precious Metals commentary in the Commodity Round-Up section. 4 The model shown in Chart 7 also includes iron ore and steel traded in China as explanatory variables. It is noteworthy that copper prices remain resilient to a collapse in iron ore prices brought on by forced closures in China of steel mills to conserve coal and natural gas supplies for human-needs use going into what is expected to be a colder-than-normal winter on the back of a second La Niña in the Northern Hemisphere. Please see our report published 30 September entitled La Niña And The Energy Transition for additional discussion. Investment Views and Themes Strategic Recommendations
Highlights The euro has entered a period of acute stress. Some of the EUR/USD’s plunge reflects the dollar’s broad-based strength. The dollar is supported by the market’s pricing of the Fed and China’s economic weakness. The euro also suffers from idiosyncratic forces. Investors appreciate better now that the Eurozone’s inflation is much narrower than that of the US. They are adjusting their ECB pricing accordingly. Europe’s growth prospects are also hurt by a renewed wave of lockdowns and China’s property woes. The revival of the European natural gas surge is the coup de grâce that is hurting the Euro. Nonetheless, euro sentiment is extremely depressed, which suggests that the euro already discounts many of these negatives. Consequently, we are adhering to our long EUR/USD trade implemented four weeks ago, but we will not re-open it if the stop-loss is triggered. Feature Four weeks ago, we tentatively recommended buying the euro, acknowledging that this view was fraught with near-term risks. However, the recent collapse in the euro forces us to revisit this stance. 2022 will be a better year for EUR/USD; nevertheless, the next three months could result in pronounced weakness in the currency, and the odds have increased that this pair might retest the pandemic lows. We are sticking with our long EUR/USD bet for now, as we have a floor under the position, the result of our stop at 1.1175. If this stop is reached, we will wait before reinstating a long euro position. What’s Going Well With The USD? The first element of the euro’s weakness is the generalized strength in the USD. The dollar is rallying against all the components of the DXY, which is pushing the USD’s Advanced/Decline line up (Chart 1). Moreover, as BCA’s Emerging Market Strategy team recently highlighted, the dollar is breaking out above its three-year moving average, which constitutes an important technical signal. The dollar strength is multi-faceted and reflects both domestic and international factors. On the domestic front, markets are responding to growing inflationary forces and signs of economic vigor to price in a more aggressive Fed outlook than two months ago (Chart 2), especially following the implementation of the Fed’s tapering program this month. Chart 1The Dollar Is Strong Chart 2More Hikes Prices In The inflation picture is of prime concern to investors. As Chart 3highlights, US core CPI is at a 30-year high and median inflation measures are also strengthening. Most concerning, inflationary pressures are broadening beyond energy and goods, with shelter prices accelerating anew (Chart 3, bottom panel). The labor market is also gearing up to move toward full employment conditions. The quits rate is near a record high, which corroborates the impression among households that jobs are easy to secure (Chart 4). Moreover, wages among low-skill employees are strengthening, which indicates that the labor market is tight (Chart 4, bottom panel). Granted, this is happening in a context in which the labor force participation rate is low, especially for women, and could rise anew, which would alleviate the labor market’s tightness. However, this process will likely entail higher wages first. Chart 3Broadening US Inflation Chart 4Getting To Maximum Employment? Economic data is also firming up, despite rises in COVID cases in many states. For example, nominal retail sales were robust in October, even if inflation contributed to their strength. Moreover, both the New York Fed’s Empire State Manufacturing Survey and the Philly Fed’s Manufacturing Business Outlook Survey highlighted an acceleration in activity (Chart 5). As a result, the Atlanta Fed’s Q4 GDPNow Forecast has rebounded to 8.2%, which would represent a marked improvement from the 2.2% quarterly annualized rate recorded in Q3. Whether or not this is an error, market participants may continue to use this economic backdrop to price in additional hikes by the Fed and feed the dollar rally. The international backdrop also helps the USD. The main positive comes from China. BCA’s emerging market strategists highlight that the weakness in the Chinese credit impulse is often a harbinger of dollar strength (Chart 6). The US economy is less exposed to manufacturing and trade than the economies of Europe, Australia, and EM, which means that it is less impacted by Chinese growth slowdowns than other parts of the world. This explains why the dollar loves a slowing Chinese economy. Chart 5A Pick Up In US Growth Chart 6The Dollar Loves A Weaker China China’s economic problems have once again become more relevant to market participants, as recent prints have been weak. Following the fall of Chinese GDP growth to 4.9% in the third quarter, new releases have shown that house prices are contracting and property investment is decelerating. These data sets are feeding the dollar rally. The dollar’s strength will beget further dollar appreciation. We have often highlighted that the dollar is the premier momentum currency within the G-10, along with the yen (Chart 7). Today, the most reliable momentum indicator for the greenback, the crossover of the 20-day MA above the 200-day one, continues to send a very supportive signal, which the economic backdrop reinforces (Chart 8). Moreover, historically, the dollar’s trading in the first few weeks of January often echoes the trend of the previous year. Hence, we may witness a continued blow off until February 2022. Chart 8Positive Momentum Signal For The Dollar Bottom Line: The dollar is breaking out on a broad basis. Not only is the US economy inviting investors to reprice the Fed’s expected policy path, but the economic weakness in China is also contributing to the rally. Technically, the dollar’s pro-momentum attribute accentuates the risk that this breakout morphs into a melt-up until February 2022, especially if US equities continue to outperform the rest of world and attract flows into the USD. The Euro’s Specific Problems Chart 9Europe Doesn't Have The US Inflation Problem The spectacular collapse in EUR/USD goes beyond the strength in the dollar, because crucial catalysts are also pushing the euro lower. First, investors are increasingly differentiating between the Eurozone and the US inflation picture. We have often made the case that European inflation is much more limited than that of the US. For example, the dynamics in the trimmed-mean inflation and the CPI adjusted for VAT highlights that lack of broad inflation in Europe (Chart 9). Moreover, recent ECB’s communications have made it eminently clear that it is in no rush to raise rates. As a result, investors have been curtailing the number of ECB hikes priced in for 2022 compared to early November. Second, European economic activity is unable to catch a break. The recent uptick of COVID-19 cases in Germany, the Netherlands, and Austria is prompting local governments to impose renewed lockdowns of various scales, as worries emerge that hospital capacity will suffer as it did last winter (Chart 10). We doubt these lockdowns will last as long or will be as severe from a pan-European perspective, but, for now, they are weighing on investor sentiment and contributing to the euro-bearish widening in US-German 2-year yield differentials (Chart 11). Chart 10A New Wave Chart 11Rate Differentials Hurt The Euro Third, the Chinese economy continues to act as a drag on Europe. China’s real estate activity is slowing, as credit spreads and share prices of property developers remain distressed (Chart 12). It is of concern that the Chinese and EM credit market stresses are broadening beyond this sector, which indicates a tightening in financial conditions for a large swath of the Eurozone’s important trading partners. Moreover, Europe’s machinery exports are particularly exposed to the Chinese construction sector. Under these circumstances, the wave of weakness in Chinese construction activity could herald additional problems for EUR/USD, since they amount to a weakening in Euro Area growth relative to the US (Chart 13). Chart 12Downside To Chinese Construction Activity Chart 13Slowing Chinese Construction Is A Threat to EUR/USD Fourth, equity outflows out of the Eurozone into the US are likely to continue as long as China suffers. BCA’s Emerging Market strategists anticipate the deterioration in China’s stock-to-bond ratio (SBR) to last, because this economy is weakening. Over the past five years, a deteriorating Chinese SBR has coexisted with a deepening underperformance of European equities relative to those of the US (Chart 14). Over this timeframe, equity flows have played a significant role in the EUR/USD exchange rate determination; thus, the weaker Chinese SBR also correlates well with a softer euro (Chart 14, bottom panel). Finally, the renewed energy crisis is particularly painful for the euro. German regulators indicated that they will temporarily suspend the approval of the Nord Stream 2 pipeline, which prompted European natural gas prices to surge anew. As Chart 15 shows, this proved to be the coup de grâce for the euro. The response of the euro to higher natural gas prices is rational. Surging natural gas prices are a growth shock for the region, yet they are unlikely to prompt a tightening in policy by the ECB, because they only push headline inflation, not the core measure. In fact, they could widen the dichotomy between underlying and headline inflation, because rising energy costs sap other spending categories. In other words, rising energy prices point to a stagflationary outcome this winter in Europe, which is poison for the euro. Chart 14More European Equity Outflows? Chart 15The Nat-Gas Coup De Grace Bottom Line: The weakness of the euro reflects more than the strength in the USD. The narrower nature of European inflation prevents a hawkish repricing of the ECB to take place, while renewed lockdowns are hurting growth sentiment. Moreover, the travails of China’s property sector are harming European economic activity, while also inviting equity outflows. Finally, the recent revival of the natural gas price surge is once again raising the specter of stagflation this winter in Europe, which is a dreadful scenario for the euro. What To Do? Our long EUR/USD bet initiated four weeks ago has a stop loss at 1.1175. Due to the bullish dollar forces and bearish euro factors described in this report, we will not re-open the trade if the stop-loss is triggered. Its activation would indicate that the bear-trend in the euro is gathering steam. When coupled with the momentum nature of the dollar and the euro’s anti-dollar behavior imparted by EUR/USD’s great market liquidity, this combination could easily push EUR/USD to 1.08 or lower by January 2022. We are not closing the trade either. While the list of euro-negative forces is long, sentiment toward EUR/USD is now quite lopsided, which suggests that a significant proportion of the euro bearish factors are already discounted. One-month, three-month, and six-month risk reversals in EUR/USD have fallen close to their Q2 2020 levels. Moreover, investors now hold large short positions in EUR/USD, especially compared to their large long bets on the DXY (Chart 16); meanwhile, the Euro Capitulation Index is now depressed relative to that of the dollar (Chart 16, bottom panel). Finally, the most important signal comes from our Intermediate-Term Timing Model (ITTM), which is an augmented interest-rate parity model that accounts for global risk aversion and the currency’s trend. The ITTM is now trading at 1 sigma, a level that has historically been followed by a positive return six months later 75% of the time since 2002 (Chart 17). Chart 16Negative Euro Sentiment Chart 17Much Pessimism Is In The Price Chart 18Peak US Inflation? Finally, the US is likely experiencing peak inflationary pressures right now. If inflation rolls over in the near future, investors will breathe a collective sigh of relief, and they will not price in more rate hikes. The decline in DRAM prices and the recent ebb in shipping costs, with the Baltic Dry down 57% from its peak and the WCI Composite Container Freight Benchmark 12% below its September apex, suggest that the most severe supply bottlenecks are passing while energy indexes are also softening (Chart 18). In this context, the best strategy remains to keep the trade open and to follow the discipline imposed by the stop loss. Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations Closed Trades Currency Performance Fixed Income Performance Equity Performance
Dear Client, There will be no report next week as we will be working on our Quarterly Strategy Outlook, which will be published the following week. In the meantime, please keep an eye out for BCA Research’s Annual Outlook, featuring long-time BCA client Mr. X, who visits towards the end of each year to discuss the economic and financial market outlook for the year ahead. Best regards, Peter Berezin Chief Global Strategist Highlights Inflation in the US, and to a lesser extent, in other major economies, will follow a “two steps up, one step down” trajectory of higher highs and higher lows. While inflation will fall in the first half of next year as goods prices stabilize, an overheated labor market will cause inflation to re-accelerate into 2023. The Fed will be slow to respond to high inflation, implying that monetary policy will remain accommodative next year. This should help propel stocks to new highs. Chinese stimulus will offset much of the drag from a weaker domestic property market. The dollar is a high momentum currency, so we wouldn’t bet against the greenback in the near term. Nevertheless, with “long dollar” now a consensus trade, we would position for a weaker dollar over a 12-month horizon. A depreciating dollar next year should help non-US equities, especially beleaguered emerging market stocks. The dollar will strengthen anew in 2023, as the Fed is forced to turn more hawkish, and global equities begin to buckle. From Ice To Fire In past reports, we have contended that inflation in the US, and to a lesser extent, in other major economies, would follow a “two steps up, one step down” trajectory of higher highs and higher lows. We are currently near the top of those two steps. The pandemic ushered in a major re-allocation of spending from services to goods (Chart 1). US inflation should dip over the next 6-to-9 months as the demand for goods decelerates and supply-chain disruptions abate. Chart 1The Pandemic Caused A Major Shift In Spending From Services To Goods CHart 2Those With Low Paid Jobs Are Enjoying Stronger Wage Gains The respite from inflation will not last long, however. The labor market is heating up. So far, most of the wage growth has been at the bottom end of the income distribution (Chart 2). Wage growth will broaden over the course of 2022, setting the scene for a price-wage spiral in 2023. We doubt that either fiscal or monetary policy will tighten fast enough to prevent such a spiral from emerging. As a result, US inflation will surprise meaningfully on the upside. Our view has no shortage of detractors. In this week’s report, we address the main counterarguments in a Q&A format: Q: What makes you think that service spending will rebound fast enough to offset the drag from weaker goods consumption? Chart 3Inventory Restocking Could Be A Source Of Growth Next Year A: There is still a lot of pent-up demand for goods. Try calling any auto dealership. You will hear the same thing: “We have nothing in stock now, but if you put in an order today, you might get a vehicle in 3-to-6 months.” Thus, durable goods sales are unlikely to weaken quickly. And with inventories near record low levels, firms will need to produce more than they sell (Chart 3). Inventory restocking will support GDP growth. As for services, real spending in the US grew by 7.9% in the third quarter, an impressive feat considering that this coincided with the Delta-variant wave. Service growth will stay strong in the fourth quarter. The ISM non-manufacturing index jumped to a record high of 66.7 in October, up from 61.9 in September. The Atlanta Fed’s GDPNow model is tracking real PCE growth of 9.2% in Q4. Goldman’s Current Activity Indicator has hooked up (Chart 4). Q: Aren’t you worried that spending on services might stall next year? A: Not really. Chart 5 shows the percentage change in real spending for various types of services from January 2020 to September 2021, the last month of available data. The greatest decline in spending occurred in those sectors that were most directly affected by the pandemic. Notably, spending on movie theaters, amusement parks, and live entertainment in September was still down 46% on a seasonally-adjusted basis compared to last January. Hotel spending was down 22%. Spending on public transport was down 26%. Only spending on restaurants was back to normal. The number of Covid cases has once again started to trend higher in the US, so that path to normalization will take time (Chart 6). Nevertheless, with vaccination rates still edging up and new antiviral drugs set to hit the market, it is reasonable to assume that many of the hardest-hit service categories will recover next year. Q: What about medical services? Some have speculated that the shift to telemedicine will require much lower spending down the road. A: It is true that spending on outpatient services in September was $43 billon below pre-pandemic levels. However, over two-fifths of that shortfall was in dental services, which are not amenable to telemedicine. Spending on dental services was down 16% from its January 2020 levels, compared to 6% for physician services. A more plausible theory is that many people are still worried about venturing to the doctor’s or dentist’s office. In addition, a lot of elective procedures were canceled or postponed due to the pandemic. Clearing that backlog will lift medical spending next year. Chart 7The Flow Of Savings Has Fallen Back To Pre-Pandemic Levels But The Stock Of Accumulated Savings Remains High In any case, the cost of a telemedicine appointment is typically no different from an in-person one. And, to the extent that telemedicine does become more widespread, this could encourage more people to seek medical assistance. Lastly, even if spending on certain services does not fully recover after the pandemic, this will probably simply result in a permanent increase in spending on goods. The only way that overall consumer spending will falter is if the savings rate rises, which seems unlikely to us. Q: Why do you say that? The savings rate has been very high throughout the pandemic. A: The savings rate did spike during the pandemic, but that was mainly because fewer services were available, and because households were getting transfer payments from the government. Now that these payments have ended, the savings rate has dropped to 7.5%, roughly where it was prior to the pandemic. There is good reason to think the savings rate will keep falling next year. Households are sitting on $2.3 trillion in excess savings, most of which reside in bank deposits (Chart 7). As they run down those savings, consumption will rise in relation to income. The household deleveraging cycle is over. After initially plunging during the pandemic, credit card balances are rising (Chart 8). Banks are eager to make consumer loans (Chart 9). Household net worth has risen by over 100% of GDP since the start of the pandemic (Chart 10). As we discussed three weeks ago, the wealth effect alone could boost annual consumer spending by up to 4% of GDP. Chart 8APost-GFC Deleveraging Has Ended And People Are Swiping Credit Cards Again Following The Pandemic Scare Chart 8BPost-GFC Deleveraging Has Ended And People Are Swiping Credit Cards Again Following The Pandemic Scare Chart 9Banks Are Easing Credit Standards For Consumer Loans Chart 10A Record Rise In Household Net Worth Q: Household wealth could fall as the Fed starts tapering and eventually raising rates. Wouldn’t that cool the economy? A: The taper is a fait accompli, and markets are already pricing in rate hikes starting in the second half of next year. If the Fed were to signal its intention to raise rates more quickly than what has been priced in, then home prices and stocks could certainly weaken. We do not think the Fed will pivot in a more hawkish direction before the end of next year, however. The Fed’s estimate of the neutral rate is only 2.5%, a big step down from its estimate of 4.25% in 2012. The market’s view is broadly in line with the Fed’s (Chart 11). Despite the upward move in realized inflation, long-term inflation expectations remain in check – expected inflation 5-to-10 years out in the University of Michigan survey has increased from 2.3% in late 2019 to 2.9%, bringing it back to where it was between 2010 and 2015. The 5-year/ 5-year forward TIPS breakeven inflation rate is near the bottom end of the Fed’s comfort zone (Chart 12). Chart 11The Fed And Investors Still Believe In Secular Stagnation Chart 12Long-Term Inflation Expectations Are Not Yet A Concern For The Fed Q: What about fiscal policy? Isn’t it set to tighten sharply next year? A: The US budget deficit will decline next year. However, this will happen against the backdrop of strong private demand growth. Moreover, budget deficits are likely to remain elevated in the post-pandemic period. This week, President Biden signed a $1.2 trillion infrastructure bill into law, containing $550 billion in new spending. BCA’s geopolitical strategists expect Congress to pass a $1.5-to-$2 trillion social spending bill using the reconciliation process. All in all, the IMF foresees the US cyclically-adjusted primary budget deficit averaging 4.9% of GDP between 2022 and 2026, compared to 2.0% of GDP between 2014 and 2019 (Chart 13). Chart 14While Overall Consumption Has Recovered, Business Spending and Direct Government Expenditures Remain Below Trend It should also be noted that government spending on goods and services has been quite weak over the past two years (Chart 14). The budget deficit surged because transfer payments exploded. Unlike direct government spending, which is set to accelerate over the next few years, households saved a large share of transfer payments. Thus, the fiscal multiplier will increase next year, even as the budget deficit shrinks. Q: We have focused a lot on demand, but what about supply? There are over 4 million fewer Americans employed today than before the pandemic and yet the job openings rate is near a record high. Chart 15Despite A Notable Decline, There Are Still A Lot Of People Avoiding Work Because Of Worries About Contracting Or Transmitting Covid A: Some people who left the workforce will regain employment. According to the Census Bureau’s Household Pulse Survey, there are still 2.5 million people not working because they are afraid of catching or transmitting the virus (Chart 15). That said, some workers may remain sidelined for a while longer. The very same survey also revealed that about 8 million of the 100 million workers currently subject to vaccine mandates say that “they will definitely not get the vaccine.” In addition, about 3.6 million workers have retired since the start of the pandemic, about 1.2 million more than one would have expected based on pre-existing demographic trends. Most of these retirees will not work again. Lifestyle choices may keep others from seeking employment. Female labor participation has declined much more during the pandemic and than it did during the Great Recession (Chart 16). While many mothers will re-enter the labor force now that schools have reopened, some may simply choose to stay at home. The bottom line is that the pandemic has reduced labor supply at a time when labor demand remains very strong. This is likely to exacerbate the labor shortage. Q: Any chance that higher productivity will offset some of the damage to the supply side of the economy from decreased labor participation? A: US labor productivity did increase sharply during the initial stages of the pandemic. However, that appears to have been largely driven by composition effects in which low-skilled, poorly-paid service workers lost their jobs. As these low-skilled workers have returned to the labor force, productivity growth has dropped. The absolute level of productivity declined by 5.0% at an annualized rate in the third quarter, leading to an 8.3% increase in labor costs. It is telling that productivity growth has been extremely weak outside the US (Chart 17). This gives weight to the view that the pandemic-induced changes in business practices have not contributed to higher productivity, at least so far. It is also noteworthy that a recent study of 10,000 skilled professionals at a major IT company revealed that work-from-home policies decreased productivity by 8%-to-19%, mainly because people ended up working longer. Increased investment spending should eventually boost productivity. Core capital goods orders, which lead corporate capex, are up 18% since the start of the pandemic (Chart 18). However, the near-term impact of increased investment spending will be to boost aggregate demand, stoking inflation in the process. Chart 18US Capex Should Pick Up Q: We have spoken a lot about the US, but the world’s second biggest economy, China, is facing a massive deflationary shock from the implosion of its real estate market. Could that deflationary impulse potentially cancel out the inflationary impulse from an overheated US economy? A: You are quite correct that inflation has risen the most in the US. While inflation has picked up in Europe, this mainly reflects base effects (Chart 19). Inflation in China has fallen since the start of the pandemic despite booming exports. There are striking demographic parallels between China today and Japan in the early 1990s. The bursting of Japan’s property bubble corresponded with a peak in the country’s working-age population (Chart 20). China’s working-age population has also peaked and is set to decline by more than 40% over the remainder of the century. Chart 19The US Stands Out As The Inflation Leader Chart 20Demographic Parallels Between China And Japan That said, there are important differences between the two nations. In 1990, Japan was a rich economy; output-per-hour was nearly 70% of US levels. China is still a middle-income economy; output-per-hour is only 20% of US levels (Chart 21). China has the ability to outgrow some of its problems in a way that Japan did not. In addition, Chinese policymakers have learned from some of Japan’s mistakes. They have been trying to curb the economy’s dependence on property development; real estate development investment has fallen from 12% of GDP in 2014 to less than 10% of GDP (Chart 22). China is still building too many new homes, but unlike Japan in the 1990s, the government is likely to pursue stimulus measures to compensate for a shrinking property sector. This should keep the economy from entering a deflationary slump. Chart 22Real Estate Investment Has Peaked In China Q: Let’s bring this back to markets. What is the main investment takeaway from your view? A: The main takeaway is that investors should remain bullish on stocks and other risk assets for the next 12 months but be prepared to turn more cautious in 2023. The neutral rate of interest in the US is higher than generally assumed. This means that monetary policy is currently more accommodative than widely believed, which is good for stocks. Unfortunately, it also means that a policy error is likely: The Fed will keep rates too low for too long, causing the economy to overheat. Chart 23Bank Stocks Tend To Outperform When Yields Rise This overheating will not be evident over the next six months. As we noted at the outset of this report, the US economy is currently at the top of the proverbial two steps in our projected “two steps up, one step down” trajectory for inflation. The cresting in durable goods inflation will provide a temporary respite from inflationary worries, even as the underlying long-term driver of higher inflation – an increasingly tight labor market – gains traction. Strong consumer demand and persistent labor shortages will incentivize companies to invest in new capacity and automate production. This will benefit industrial stocks and select tech names. Rising bond yields will also boost bank shares (Chart 23). A country’s current account balance is simply the difference between what it saves and what it invests. With savings on the downswing and investment on the upswing, the US will find it increasingly difficult to finance its burgeoning trade deficit. The US dollar is a high momentum currency, so we wouldn’t necessarily bet against the greenback in the near term (Chart 24). Nevertheless, with “long dollar” now a consensus trade, we would position for a weaker dollar over a 12-month horizon (Chart 25). Chart 25Long Dollar Is A Crowded Trade Chart 26A Depreciating Dollar Next Year Should Help Non-US Equities A depreciating dollar next year should help non-US equities, especially beleaguered emerging markets (Chart 26). The dollar will strengthen anew in 2023, as the Fed is forced to turn more hawkish, and global equities begin to buckle. Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores
Highlights Remain neutral on the US dollar. A breakout of the dollar would cause a shift in strategy. Russia’s conflict with the West is heating up now that Germany has delayed the certification of the Nord Stream II pipeline. As long as the focus remains on the pipeline, the crisis will dissipate sometime in the middle of next year. But there is an equal chance of a massive escalation of strategic tensions. Our GeoRisk Indicators will keep rising in Europe, negatively affecting investor risk appetite. Stick with DM Europe over EM Europe stocks. If the dollar does not break out, South Korea and Australia offer cyclical opportunities. Turkish and Brazilian equities will not be able to bounce back sustainably in the midst of chaotic election cycles and deep structural problems. Rallies are to be faded. Feature We were struck this week by JP Morgan CEO Jamie Dimon’s claim that his business will “not swayed by geopolitical winds.”1 If he had said “political winds” we might have agreed. It is often the case that business executives need to turn up their collars against the ever-changing, noisy, and acrimonious political environment. However, we take issue with his specific formulation. Geopolitical winds cannot shrugged off so easily – or they are not truly geopolitical. Geopolitics is not primarily about individual world leaders or topical issues. It is primarily about things that are very hard and slow to change: geography, demography, economic structure, military and technological capabilities, and national interests. This is the importance of having a geopolitically informed approach to macroeconomics and financial markets: investment is about preserving and growing wealth over the long run despite the whirlwind of changes affecting politicians, parties, and local political tactics. In this month’s GeoRisk Update we update our market-based, quantitative geopolitical risk indicators with a special focus on how financial markets are responding to the interplay of near-term and cyclical political risks with structural and tectonic pressures underlying a select group of economies and political systems. Is King Dollar Breaking Out? Chart 1King Dollar Breaking Out? Our first observation is that the US dollar is on the verge of breaking out and rallying (Chart 1). This potential rally is observable in trade-weighted terms and especially relative to the euro, which has slumped sharply since November 5th. Our view on the dollar remains neutral but we are watching this rally closely. This year was supposed to be a year in which global growth recovered from the pandemic on the back of vaccination campaigns, leading the counter-cyclical dollar to drop off. The DXY bounce early in the year peaked on April 2nd but then began anew after hitting a major resistance level at 90. The United States is still the preponderant power within the international system. The USD remains the world’s leading currency by transactions and reserves. The pandemic, social unrest, and contested election of 2020 served as a “stress test” that the American system survived, whether judging by the innovation of vaccines, the restoration of order, or the preservation of the constitutional transfer of power. Meanwhile Europe faces several new hurdles that have weighed on the euro. These include the negative ramifications of the slowdown in Asia, energy supply shortages, a new wave of COVID-19 cases, and the partial reimposition of social restrictions. Moreover the Federal Reserve is likely to hike interest rates faster and higher than the European Central Bank over the coming years. Potential growth is higher in the US than Europe and the US growth is supercharged by fiscal stimulus whereas Europe’s stimulus is more limited. Of course, the US’s orgy of monetary and fiscal stimulus and ballooning trade deficits raise risks for the dollar. Global growth is expected to rotate to other parts of the world over the coming 12 months as vaccination spreads. There is still a chance that the dollar’s bounce is a counter-trend bounce and that the dollar will relapse next year. Hence our neutral view. Yet from a geopolitical perspective, the US population and economy are larger, more dynamic, more innovative, safer, and more secure than those of the European Union. The US still exhibits an ability to avoid the reckoning that is overdue from a macroeconomic perspective. Russia-West Conflict Resumes In our third quarter outlook we argued that European geopolitical risk had hit a bottom, after coming off the sovereign debt crisis of 2010-15, and that geopolitical risk would begin to rise over the long term for this region. Our reasoning was that the markets had fully priced the Europeans’ decision to band together in the face of risks to the EU’s and EMU’s integrity. What markets would need to price going forward would be greater risks to Europe’s stability from a chaotic external environment that Europe lacked the willingness or ability to control: conflict with Russia, immigration, terrorism, and the slowdown in Asia. In particular we argued that Russia’s secular conflict with the West would resume. US-Russia relations would not improve despite presidential summits. The Nord Stream II pipeline would become a lightning rod for conflict, as its operation was more likely to be halted than the consensus held. (German regulators paused the approval process this week, raising the potential for certification to be delayed past the expected March-May months of 2022.) Most importantly we argued that the Russian strategy of political and military aggression in its near-abroad would continue since Russia would continue to feel threatened by domestic instability at home and Western attempts to improve economic integration and security coordination with former Soviet Union countries. Chart 2Putin Showdown With West To Escalate Further For this reason we recommended that investors eschew Russian equities despite a major rally in commodity prices. Any rally would be undercut by the slowing economy in Asia or geopolitical conflicts that frightened investors away from Russian companies, or both. Today the market is in the process of pricing the impact on Russian equities from commodity prices coming off the boil. But politics may also have something to do with the selloff in Russian equities (Chart 2). The selloff can continue given still-negative hard economic data from Asia and the escalation of tensions around Russia’s strategically sensitive borders: Ukraine, Belarus, Poland, Lithuania, Moldova, and the Black Sea. The equity risk premium will remain elevated for eastern European markets as a result of the latest materialization of country risk and geopolitical risk – the long running trend of outperformance by developed Europe has been confirmed on a technical resistance level (Chart 3). Our mistake was closing our recommendation to buy European natural gas prices too early this year. Chart 3Favor DM Europe Amid Russia Showdown In early 2021, our market-based geopolitical risk indicator for Russia slumped, implying that global investors expected a positive diplomatic “reset” between the US and Russia. We advised clients to ignore this signal and argued that Russian geopolitical risk would take back off again. We said the same thing when the indicator slumped again in the second half of the year and now it is clear the indicator will move sharply higher (Chart 4). The point is that geopolitics keeps interfering with investors’ desire to resuscitate Russian equities based on macro and fundamental factors: cheap valuations, commodity price rises, some local improvements in competitiveness, and the search for yield. Chart 4Russian GeoRisk Indicator - Risks Not Yet Priced Russia may or may not stage a new military incursion into Ukraine – the odds are 50/50, given that Russia has invaded already and has the raw capability in place on Ukraine’s borders. The intention of an incursion would be to push Russian control across the entire southern border of Ukraine to Odessa, bringing a larger swathe of the Black Sea coast under Moscow’s control in pursuit of Russia’s historic quest for warm water ports. The limitations on Russia are obvious. It would undertake new military and fiscal burdens of occupation, push the US and EU closer together, provoke a stronger NATO defense alliance, and invite further economic sanctions. Yet similar tradeoffs did not prevent Russia from taking surprise military action in Georgia in 2008 or Ukraine in 2014. After the past 13 years the US and EU are still uncoordinated and indecisive. The US is still internally divided. With energy prices high, domestic political support low, and Russia’s long-term strategic situation bleak, Moscow may believe that the time is right to expand its buffer territory further into Ukraine. We cannot rule out such an outcome, now or over the next few years. If Russia attacks, global risk assets will suffer a meaningful pullback. It will not be a bear market unless the conflict spills out beyond Ukraine to affect major economies. We have not taken a second Ukraine invasion as our base case because Russia is focused primarily on getting the Nord Stream pipeline certified. A broader war would prevent that from happening. Military threats after Nord Stream is certified will be more worrisome. A less belligerent but still aggressive move would be for Russia to militarize the Belarussian border amid the conflict with the EU over Belarus’s funneling of Middle Eastern migrants into the EU via Poland and Lithuania. A closer integration of Russia’s and Belarus’s economies and militaries would fit with Russia’s grand strategy, improve Russia’s military posture in eastern Europe, and escalate fears of eventual war in Poland and the Baltic states. The West would wring its hands and announce more sanctions but may not have a higher caliber response as such a move would not involve hostilities or the violation of mutual defense treaties. This outcome would be negative but also digested fairly quickly by financial markets. Our European GeoRisk Indicators (see Appendix) are likely to respond to the new Russia crisis, in keeping with our view that European geopolitical risk will rise in the 2020s: German risk has dropped off since the election but will now revive at least until Nord Stream II is certified. If Russia re-invades Ukraine it will rise, as it did in 2014. French risk was already heating up due to the presidential election beginning April 10 (first round) but now may heat up more. Not that Russia poses a direct threat to France but more that broader regional insecurities would hurt sentiment. The election itself is not a major risk to investors, though terrorist attacks could tick up. President Macron has an incentive to be hawkish on a range of issues over the next half year. The UK is in the midst of the Russia conflict. Its defense cooperation with Ukraine and naval activity in the Black Sea, such as port calls in Georgia, have prompted Russia’s military threats – including a threat to bomb a Royal Navy vessel earlier this year. Not to mention ongoing complications around Brexit. The Russian situation is by far the most significant factor. Spain is at a further remove from Russia but its risks are rising due to domestic political polarization and the rising likelihood of a breakdown in the ruling government. Bottom Line: We still favor these countries’ equities to those of eastern Europe but our risk indicators will rise, suggesting that geopolitical incidents could cause a setback for some or all of these markets in absolute terms. A pickup in Asian growth would be beneficial for developed European assets so we are cyclically constructive. We remain neutral on the USD-EUR though a buying opportunity may present itself if and when the Nord Stream II pipeline is certified. Korea: Nobody’s Heard From Kim In A While Chart 5Korea GeoRisk Indicator Still Elevated Geopolitical risk has risen in South Korea due to COVID-19 and its aftershocks, including supply kinks, shortages, and policy tightening by the giant to the West (Chart 5). South Korea’s geopolitical risk indicator is still very high but not because of North Korea. Our Dear Leader Kim Jong Un has not been overly provocative, although he has restarted the cycle of provocations during the Biden administration. Yet South Korean geopolitical risk has skyrocketed. The problem is that investors have lost a lot of appetite for South Korea in a global environment in which demographics are languishing, globalization is retreating, a regional cold war is developing, and debt levels are high. Domestic politics have become more redistributive without accompanying reforms to improve competitiveness or reform corporate conglomerates. The revival of the South Korean conservatives ahead of elections in 2022 suggests political risk will remain elevated. Of course, North Korea could still move the dial. A massive provocation, say something on the scale of the surprise naval attack on the Chonan in the wake of the global financial crisis in spring of 2010, could push up the risk indicator higher and increase volatility for the Korean won and equities. Kim could take such an action to insist that President Biden pay heed to him, like President Trump did, or at least not ignore him, in a context in which Biden is doing just that due to far more pressing concerns. Biden would be forced to reestablish a credible threat. Still, North Korea is not the major factor today. Not compared to the economic and financial instability in the region. At the same time, if global growth surprises pick up and the dollar does not break out, Korea will be a beneficiary. We have taken a constructive cyclical view, although our specific long Korea trade has not worked out this year. Korean equities depreciated by 11.2% in USD terms year-to-date, compared to 0.3% for the rest of EM. Structurally, Korea cannot overcome the negative demographic and economic factors mentioned above. Geopolitically it remains a “shrimp between two whales” and will fail to reconcile its economic interests with its defense alliance with the United States. Australia: Wait On The Dollar Chart 6Australian GeoRisk Indicator Still Elevated Australian geopolitical risk has not fallen back much from this year’s highs, according to our quant indicator (Chart 6). Global shortages and a miniature trade war were the culprits of this year’s spike. The advantage for Australia is that commodity prices and metals look to remain in high demand as the world economy fully mends. Various nations are implementing large public investment programs, especially re-gearing their energy sectors to focus more on renewables. The reassertion of the US security alliance is positive for Australia but geopolitical risk is rising on a secular basis regardless. Cyclically we would look positively toward Australian stocks. Yet they have risen by 4.3% in common currency terms this year so far, compared to the developed market-ex-US average of 11.0%. Moreover the Aussie’s latest moves confirm that the US dollar is on the verge of breaking out which would be negative for this bourse. Structurally Australia will go through a painful economic transition but it will be motivated to do so by the new regional cold war and threats to national security. The US alliance is a geopolitical positive. Turkey And Brazil The greenback’s rally could be sustainable not only because of the divergence of US from Asian and global growth but also because of the humiliating domestic political environment of most prominent emerging markets. Chart 7Emerging Market Bull Trap We booked gains our “short” trade of the currencies of EM “strongmen,” such as Brazil’s Jair Bolsonaro and Turkey’s Recep Erdogan, earlier this year. But we noted that we still hold a negative view on these economies and currencies. This is especially true today as contentious elections approach in both countries in 2022 and 2023 respectively (Chart 7). Turkey is trapped into an inflation spiral of its own design, which enervates the economy, as our Emerging Markets Strategy has shown. It is also trapped in a geopolitical stance in which it has repeatedly raised the stakes in simultaneous clashes with Russia, the US, Europe, Israel, the Arab states, Libya, and Iran. Russia’s maneuvers in the Black Sea are fundamentally threatening to Turkey, so while Erdogan has maintained a balance with Russia for several years, Russian aggression could upset that balance. Turkey has backed off from some recent confrontations with the West lately but there is not yet a trend of improvement. The COVID-19 crisis gave Erdogan a badly needed bump in polls, unlike other EM peers. But this simply reinforces the market’s overrating of his odds of being re-elected. In reality the odds of a contested election or an election upset are fairly high. New lows in the lira show that the market is reacting to the whole negative complex of issues around Turkey. But the full weight of the government’s mismanaging of economic policy to stay in power and stay geopolitically relevant has not yet been felt. The election is still 19 months away. A narrow outcome, for or against Erdogan and his party, would make things worse, not better. Brazil’s domestic political and geopolitical risks are more manageable than Turkey’s. But it faces a tumultuous election in which institutional flaws and failures will be on full display. Investors will try to front-run the election believing that former President Luiz Inácio Lula da Silva will restore the good old days. But we discourage that approach. We see at least two massive hurdles for the market: first, Brazil has to pass its constitutional stress test; second, the next administration needs to be forced into difficult decisions to preserve growth and debt management. These will come at the expense of either growth or the currency, according to our Emerging Markets Strategy. We still prefer Mexican stocks. Geopolitically, Turkey will struggle with Russia’s insecurity and aggression, Europe’s use of economic coercion, and Middle Eastern instability. Brazil does not have these external problems, although social stability will always be fragile. Investment Takeaways The dollar is acting as if it may break out in a major rally. Our view has been neutral but our generally reflationary perspective on the global economy is being challenged. Russia’s conflict with the West will escalate, not de-escalate, in the wake of Germany’s decision to delay the certification of the Nord Stream II pipeline. Russia has greater leverage now than usual because of energy shortages. A re-invasion of Ukraine cannot be ruled out. But the pipeline is Russia’s immediate focus. Investors have seen conflict in Ukraine so they will be desensitized quickly unless the conflict spreads into new geographies or spills out to affect major economies. The same goes for trouble on Belarus’s borders. Stick with long DM Europe / short EM Europe. Opportunities may emerge to become more bullish on the euro and European equities if and when the Nord Stream II situation looks to be resolved and Asian risks to global growth are allayed. If the dollar does not break out, South Korea and Australia are cyclical beneficiaries. Whereas “strongman” regimes will remain volatile and the source of bull traps, especially Turkey. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 “JP Morgan chief becomes first Wall Street boss to visit during pandemic,” Financial Times, November 15, 2021, ft.com. Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Open Trades & Positions Section II: Appendix: GeoRisk Indicator Russia United Kingdom Germany France Italy Canada Spain Korea Turkey Brazil Australia South Africa Section III: Geopolitical Calendar
Highlights China’s slowdown will deepen, and US bond yields will likely rise. This augurs well for the US dollar but will produce a toxic cocktail for EM. The recent weakness in the commodity complex will continue. EM markets are at risk in absolute terms and will continue to underperform their DM counterparts. From a global macro perspective, the US dollar’s appreciation will be a re-balancing act. In a world where China is exporting economic weakness/deflation and the US is experiencing genuine inflation, a strong US dollar is desirable. The latter will redistribute inflation away from the US to the rest of the world and will redirect disinflationary pressures from the rest of the world to the US. Feature Chart 1DXY Breakout, EM FX Breakdown The US dollar is breaking out and EM currencies are breaking down (Chart 1). This will set in motion a number of responses in global financial markets. These include but are not limited to selloffs in EM equities, domestic bonds and EM credit markets and a setback in the commodity complex. Hence, we reiterate our negative stance on EM stocks and fixed-income markets. We continue to recommend shorting a basket of EM currencies versus the US dollar. Please refer to the end of this report for detailed investment recommendations. Why The Greenback Is Set To Strengthen Since early in the year, our investment strategy has been based on two macro themes: China’s slowdown and rising US inflation. We concluded early on that these dynamics are positive for the US dollar. Both macro themes have played out fairly well, yet until recently the broad trade-weighted US dollar’s advance has been hesitant. Odds are that the rally in the greenback is about to accelerate. Chart 2China's Slowdown = US Dollar Rally The fundamental case for the US dollar rally remains as follows: China’s slowdown will weigh more on emerging Asia, Japan, Europe, and/or commodity producing, developing and developed economies than it will on the US. The basis is that US exports to China make up only 0.7% of its GDP. The same ratio is much higher for the rest of the world. Hence, the US economy will outperform many advanced and emerging economies. Chart 2 illustrates that, historically, whenever China has slowed down, the US dollar has rallied. The mainland’s property construction is shrinking, and traditional infrastructure investment is also extremely weak (Chart 3). Beijing is easing its regulatory and macro policies but only by degrees. For now, policy support will be insufficient to reverse the business cycle downturn. In the meantime, the US economy is overheating. Specifically, all core type inflation measures have surged to well above 2% (Chart 4). Critically, nominal wages are rising at the fastest rate seen in the past 35 years (Chart 5). Chart 3China: Infrastructure Investment Is Very Weak Chart 4US Core Inflation Is Broad-Based And High Given that the employee quit rate is very high, employers will have to grant notable wage increases to both new and current employees. Thus, wage growth will accelerate further. Recent wage gains have not been offset by productivity growth. As a result, unit labor costs are rising (Chart 6). This will push businesses to raise their selling prices. So long as household income and consumption remain robust, businesses will likely succeed in raising their prices. In short, US inflation is acute and genuine, and, hence, it will persist unless the economy slows considerably. Chart 5US Nominal Wage Growth Is At Its Fastest In 35 Years Chart 6US Unit Labor Costs Are Rising Fast The rise in US inflation will initially be bullish for the US dollar. The reason is that fixed-income markets will move to price in higher Fed funds rates and the Fed will also acknowledge the need to hike rates given that core inflation is well above its target range. At some point in future, however, high inflation will start hurting the US dollar. This will happen when the Fed eschews rate hikes and falls behind the inflation curve. We believe we are still in a window where US bond yields could rise further. Rising US interest rates will support the dollar. Finally, the US economy, but not necessarily its equity and credit markets, is better positioned to handle central bank tightening than are other DM and EM economies. American consumers have substantially deleveraged and there are shortages in US housing and cars. Even as US borrowing costs rise, interest rate sensitive sectors like housing and autos will still do well because of pent-up demand. In particular, the US housing market is sensitive to long-term (30-year) mortgage rates and not the front end of curve. On the contrary, many EM and other DM economies and their housing sectors are sensitive to domestic short-term rates. In percentage terms, the rise in US mortgage rates will likely be smaller than those in DM and EM economies. In short, the US economy will not slow sharply in the response to rates while EM and other DM economies will. This augurs well for the dollar. The key US vulnerability from higher interest rates stems from its equity and credit markets, not the real economy. US equities and credit markets are very richly priced, so the rising cost of capital could trigger a major selloff. In turn, wealth effects and tightening financial conditions will pose a risk to the real economy. However, even in this case, the US dollar will initially appreciate because it always rallies during risk-off phases. The greenback’s depreciation will resume when the Fed turns dovish again. From a big picture macro perspective, the US dollar’s appreciation will be a re-balancing act. In a world where China is exporting economic weakness/deflation and the US is experiencing genuine inflation, a strong US dollar is desirable. The latter will redistribute inflation away from the US to the rest of the world and will redirect disinflationary pressures from the rest of the world to the US. In this period of US dollar strength, EM financial markets will be hurt because foreign investors always flee EM when their currencies depreciate. Bottom Line: China’s slowdown will deepen, and US bond yields will likely rise. This will produce a toxic cocktail for EM. Watch Out Commodity Prices Chart 7Reduced Financing For Property Developers = Less Construction The downturns in China’s property construction and traditional infrastructure spending are bad for raw material prices. The following points offer an explanation as to why commodity prices will relapse in spite of the fact that they have thus far resisted China’s slowdown. Although Chinese property sales and starts have been shrinking, floor area completed (construction work) has been very strong. However, the liquidity crunch that many real estate developers are experiencing will lead them to halt or cut back on their construction work (Chart 7, top panel). The latter will weigh on raw material prices (Chart 7, bottom panel). Taiwan’s new export orders PMI for the basic materials sector has dropped below 50, indicating plunging regional demand for raw materials (Chart 8). Ongoing weakness in Chinese demand is the culprit behind this drop. Due to electricity shortages, mainland production of industrial metals has plunged (Chart 9, top panel). Yet, the prices of these metals have recently corrected (Chart 9, bottom panel). Falling prices amid shrinking supply are a sign of major demand relapse. Chart 8Greater China: Orders For Basic Materials Are Already Shrinking Chart 9Base Metal Price Falling Despite Production Shutdowns In China The Baltic Dry index – the price of shipping bulk commodities – has rolled over decisively. It has reasonable correlation with industrial metal prices. Oil is much less exposed than base metals to China’s property and infrastructure contraction. In the case of crude, the key risks are the US and China releasing their strategic reserves and the US dollar strength. Bottom Line: The recent weakness in the commodity complex will continue. Other Considerations Chart 10China's Onshore Stock-to_Bond Ratio Is Breaking Down There are a number of other considerations and indicators that lead us to maintain a negative stance on EM financial markets: China’s onshore stock-to-bond ratio has broken below its 200-day moving average (Chart 10). This signifies a deepening growth slump in China. EM equity underperformance has been broad-based. Both the market cap-weighted and equal-weighted EM equity indexes have been underperforming their respective DM indexes. Further, not only have TMT (technology, media and telecom) stocks been underperforming their DM peers, but non-TMT stocks have also lagged their counterparts substantially (Chart 11). Last but not least, EM TMT stocks remain at risk. First, share prices of Chinese internet companies will continue derating due to structurally lower profitability going forward as the government exercises more control over them. We have discussed this in previous reports. In addition, consumer spending online has slowed sharply while smartphone sales are plunging (Chart 12). Chart 11EM Equity Underperformance Is Broad-Based Chart 12China: Online Spending Is Very Weak Second, DRAM (memory chip) prices are deflating and the value of DRAM sales is shrinking (Chart 13). This is weighing on Korean semiconductor share prices like Samsung and SK Hynix. These stocks have a large market cap in the KOSPI index. Finally, demand for semiconductors produced by Taiwanese companies has been booming but it is presently showing signs of moderation (Chart 14). Chart 13Falling DRAM Prices Are Weighing On Korean Semi Stocks Chart 14Taiwanese Semiconductor Industry: Moderating Orders Importantly, geopolitical risks around Taiwan in general and TSMC in particularly are enormous. The latter is literally at the center of the US-China confrontation. The timing of a diplomatic or even military crisis is uncertain but our Geopolitical Strategy team expects geopolitical risks over Taiwan to escalate substantially. The recent summit between Presidents Joe Biden and Xi Jinping does not change this assessment. Investment Recommendations Chart 15EM Credit Markets: Prepare For A Broad Selloff Continue underweighting EM equities in a global equity portfolio. Within the EM space, our overweights are Korea, Singapore, China (favoring A shares over investable stocks), Vietnam, Russia, central Europe and Mexico. Concerning EM equity sectors, we reiterate the short EM banks / long DM banks and short EM banks / long EM consumer staples positions. In line with our US dollar breakout thesis, we continue to recommend a short position in a basket of the following EM currencies versus the US dollar: BRL, CLP, COP, PEN, ZAR, TRY, THB, PHP and KRW. EM exchange rate depreciation is bad for EM domestic bonds. Currency weakness could lead central banks in Latin America to hike rates further. In brief, the risk-reward of EM local currency bonds is still unattractive. In this space, we recommend the following positions: bet on yield curve flattening in Mexico and Russia (pay 1-year/receive 10-year swap rates); pay Czech 10-year swap rates; receive Chinese and Malaysian 10-year swap rates. We reiterate our underweight in EM credit (both sovereign and corporate) markets versus US corporate credit, quality adjusted. As EM exchange rates depreciate, EM credit spreads will widen (Chart 15). Chinese high-yield corporate US dollar bonds are not yet a buy because the mainland property market’s travails are far from over, as was discussed in our recent Special Report. For a complete list of our recommendations across all asset classes and country strategy within each asset class, please see below or visit our web site. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations
Highlights On a 2-3 year horizon, stay overweight the US stock market, in absolute terms and relative to the non-US stock market… …and stay overweight the US dollar. A good model for the US stock market is the 30-year T-bond price multiplied by US profits. A good model for the non-US stock market is the 2-year T-bond price multiplied by non-US profits. A major long-term risk to the US stock market comes from the blockchain, which is set to return the ownership and control of our data and digital content back to us – from Facebook, Google, and the other tech behemoths that currently control, manipulate, and monetise it… …but this risk is only likely to manifest itself on a 5-10 year horizon. Fractal analysis: The Israeli shekel is overbought. Feature Chart of the WeekThe US Stock Market = The 30-Year T-Bond Multiplied By US Profits Fears that inflation will stay stubbornly high have lit a fuse under short-dated bond yields. But further along the curve, longer-dated bonds have remained an oasis of relative calm. Indeed, the 30-year T-bond yield stands 50 bps lower today than it stood in March. Given that long-duration bonds underpin the valuation of long-duration stocks, the relative calm of the 30-year bond yield explains the relative calm of the stock market in the face of higher short-term bond yields. The corollary is that substantially higher 30-year yields would threaten that calm. Inflation Will Crash Back To Earth In 2022 The relative calm of the 30-year bond yield is telling central banks: go ahead and hike rates if you want. You’ll just have to slash them again and, on average, keep them lower than you would if you didn’t hike them so soon. Rate hikes work by choking aggregate demand, but aggregate demand doesn’t need choking. Aggregate demand is barely on its pre-pandemic trend in the US, and remains far below its pre-pandemic trend in other major economies, such as the UK, Germany, and France. The pre-pandemic trend is important because it is our best estimate of potential supply. On this best estimate, aggregate demand is still below potential supply (Chart I-2). Chart I-2The 30-Year T-Bond Yield Sees That Aggregate Demand Is Fragile If aggregate demand is below potential supply, then what can explain the recent surge in inflation? The answer is the massive and unprecedented displacement of demand from services to goods, combined with modern manufacturing processes unable to meet even a 5 percent excess demand, let alone the 26 percent excess demand for durables recently experienced in the US (Chart I-3). Chart I-3The Booming Demand For Goods Is Crashing Back To Earth While Services Remain In Shortfall Yet as we highlighted last week in The Global Demand Shortfall Of 2022, the recent booming demand for goods is crashing back to earth while the demand for some services will remain structurally below the pre-pandemic trend. Combined with a tsunami of supply that will hit the global economy with a lag, inflation is also likely to crash back to earth by late 2022. The US Stock Market = The 30-Year T-Bond Multiplied By US Profits An important characteristic of any investment is its duration. If all an investment’s cashflows were converted into one ‘lump-sum’ cashflow, then the duration of the investment quantifies how far into the future that lump-sum cashflow would be. For a bond, the duration also equals the percentage change in its price for every 1 percent change in its yield.1 Interestingly, the durations of the US stock market and the 30-year T-bond are very similar, at around 25 years. Therefore, all else being equal, the US stock market should track the 30-year T-bond price. Of course, all else is not equal. The 30-year T-bond has fixed cashflows, whereas the stock market has cashflows that track profits. Allowing for this key difference, the US stock market should track: (The 30-year T-bond price) multiplied by (US profits) multiplied by (a constant) In which the constant connects current profits to the theoretical lump-sum payment 25 years ahead, thereby quantifying the structural growth of profits. But to the extent that the constant does not change, we can ignore it. Simplistic as this model appears, it does provide an excellent explanation for the US stock market’s evolution through the past 40 years (Chart of the Week and Chart I-4) – with deviations from the ‘fair-value’ giving a good gauge of the market’s over- or under-valuation. Chart I-4The US Stock Market = The 30-Year T-Bond Multiplied By US Profits Looking ahead, there are three ways in which the structural bull market could end: If the overvaluation (deviation from fair-value) became so extreme that a substantial decline in price was required to re-converge with the 30-year T-bond price multiplied by profits. If the 30-year T-bond price could no longer rise to counter a substantial decline in profits. If the constant that links current profits to future profits phase-shifted down, implying that the growth rate of US stock market profits had phase-shifted down – as happened for non-US stock market profits after the dot com bust (Chart I-5). Going through each of these, the US stock market’s current overvaluation of around 10 percent is not so extreme as to be a structural impediment. Chart I-5The Valuation Of The Non-US Stock Market Phase-Shifted Down Meanwhile, the 30-year T-bond yield has scope to decline by at least 150 bps, equating to a 40 percent counterweight to a decline in profits. Hence, this is not a structural impediment either, but will become one once the 30-year T-bond yield reaches 0.5 percent in the next deflationary shock. As for a phase-shift down in profit growth, this is a genuine long-term risk. The main risk comes from the blockchain and its threat to the pseudo-monopoly status that the US tech behemoths have in owning, controlling, manipulating, and monetising our data and the digital content that we create. The blockchain is set to return that ownership and control back to us, to the detriment of Facebook, Google, and the other behemoths of the US stock market. However, this is a long-term risk, likely to manifest itself on a 5-10 year horizon. We conclude that on a 2-3 year horizon, investors should own the US stock market. The Non-US Stock Market = The 2-Year T-Bond Multiplied By Non-US Profits We can extend the preceding analysis to the non-US stock market, with two differences. First, the non-US stock market has a much shorter duration given its much lower exposure to growing cashflows. A higher weighting to financials – which underperform when long yields are falling – further lowers the effective duration to just 2 years (empirically). Second, and obviously, the non-US stock market depends on non-US profits (Chart I-6). Chart I-6The Non-US Stock Market = The 2-Year T-Bond Multiplied By Non-US Profits It follows that the non-US stock market tracks: (The 2-year T-bond price) multiplied by (non-US profits) We can now decompose the post dot com performance of the US and non-US stock markets into their underlying structural components. The US stock market has received a massive tailwind: a 60 percent increase in the 30-year T-bond price plus a 200 percent increase in profits (Chart I-7). While the non-US stock market has received a lesser tailwind: a 10 percent increase in the 2-year T-bond price plus a 60 percent increase in profits (Chart I-8).2 Chart I-7The US Stock Market Has A Powerful Tailwind... Chart I-8...The Non-US Stock Market Has A Weak Tailwind Therefore, over the past two decades, the non-US stock market has been hampered by its low duration and by its profits that are fossilised, both metaphorically and literally. Metaphorically fossilised, because the non-US stock market is over-exposed to industries that are in structural decline such as financials and basic resources. And literally fossilised, because it is also over-exposed to the dying fossil fuel industry. Looking ahead, there are three ways that non-US stocks could outperform US stocks: If the relative valuation (deviation from respective fair-values) became extreme in favour of non-US stocks. If the 2-year T-bond price outperformed the 30-year T-bond price – effectively meaning that the 30-year T-bond price would have to fall far given that the 2-year T-bond is like cash. If non-US profits outperformed US profits. Going through each of these: both the US and non-US stock markets appear similarly overvalued versus their respective fair-values; the 30-year T-bond is unlikely to fall far given that it would destabilise the global financial system; and fossilised non-US profits are unlikely to outperform those in the US in the next few years. We conclude that on a 2-3 year horizon, investors should stay overweight the US stock market relative to the non-US stock market. One final consideration is the US dollar. Successive deflationary shocks – the 2008 GFC, the 2015 EM recession, and the 2020 pandemic – have taken the greenback to new highs as capital flows have flooded into US T-bonds (Chart I-9). It follows that the ultimate high in the dollar will coincide with the ultimate low in the 30-year T-bond yield. Chart I-9Successive Deflationary Shocks Take The Dollar To New Highs Stay structurally overweight the US dollar. The Israeli Shekel Is Overbought In this week’s fractal analysis, we note that the strong recent rally in ILS/GBP has reached the point of maximum fragility on its 130-day fractal structure that has signalled several previous reversals (Chart I-10). Chart I-10The Israeli Shekel Is Overbought On this basis, a recommended trade would be short ILS/GBP, setting a profit target and symmetrical stop-loss at 4.2 percent. Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 Defined fully, the duration of an investment is the weighted average of the times of its cashflows, in which the weights are the present values of the cashflows. 2 From January 1, 2005. Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields ##br##- Asia Chart II-4Indicators To Watch - Bond Yields ##br##- Other Developed Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Highlights US growth will slow next year, not because demand will falter, but because supply-side constraints will prevent the economy from producing as much output as households and businesses want to buy. If aggregate demand exceeds aggregate supply, the price level will rise. We argue that the US aggregate demand curve is currently quite steep. This implies that the price level may need to rise a lot to restore balance to the economy. In fact, if the aggregate demand curve is not just steep but upward-sloping, which is quite possible, there may be no price level that brings aggregate demand in line with supply; the US economy could go supernova. When supply is the binding constraint to growth, investors need to throw the old playbook for dealing with growth slowdowns out the window. Rather than positioning for lower bond yields, investors should position for higher yields. Rather than expecting a stronger dollar, investors should expect a weaker one. Rather than favoring growth stocks, large caps, and defensives, investors should favor value stocks, small caps, and cyclicals. The Binding Constraint To Growth Is Now Supply After a post-Delta wave rebound in Q4, the US economy is expected to slow over the course of 2022. The Bloomberg consensus is for US growth to decelerate from 4.9% in 2021Q4 to 4.1% in 2022Q1, 3.9% in 2022Q2, 3.0% in 2022Q3, and 2.5% in 2022Q4. Growth in the first quarter of 2023 is expected to dip further to 2.3%. We agree that US growth will slow next year but think the market narrative around this slowdown is misguided. Chart 1Plenty Of Pent-Up Demand The standard market playbook for dealing with an economic slowdown is to position for lower bond yields, a stronger US dollar, and a decline in commodity prices. On the equity side, the playbook calls for shifting equity exposure from cyclicals to defensives, favoring large caps over small caps, and growth stocks over value stocks. There are two major problems with this narrative. First, growth is peaking at much higher levels than before and is unlikely to return to trend at least until the second half of 2023. Second, and more importantly, US growth will slow due to supply-side constraints rather than inadequate demand. US final demand will remain robust for the foreseeable future. Households are sitting on $2.3 trillion in excess savings, equivalent to 15% of annual consumption (Chart 1). The household deleveraging cycle is over. After initially plunging during the pandemic, credit card balances are rising (Chart 2). Banks are falling over themselves to make consumer loans (Chart 3). Chart 2Revolving Credit On The Rise Again Chart 3Banks Are Easing Credit Standards For Consumers Chart 4A Record Rise In Household Net Worth Household net worth has risen by over 100% of GDP since the start of the pandemic (Chart 4). As we discussed two weeks ago, the wealth effect alone could boost annual consumer spending by up to 4% of GDP. Investment demand should remain strong. Business inventories are near record low levels (Chart 5). Core capital goods orders, a leading indicator for corporate capex, have soared (Chart 6). Chart 5Business Inventories Are Near Record Low Levels Chart 6Rise In Durable Goods Orders Bodes Well For Capex Chart 7The Homeowner Vacancy Rate Is Signaling The Need For More Homebuilding The Dodge Momentum Index, which tracks planned nonresidential construction, rose to a 13-year high in October. The homeowner vacancy rate is at multi-decade lows, signifying the need for more homebuilding (Chart 7). While increased investment will augment the nation’s capital stock down the road, the short-to-medium term effect will be to inflate demand. Policy Won’t Tighten Enough To Cool The Economy What is the mechanism that will push down aggregate demand growth towards potential GDP growth? It is unlikely to be policy. While budget deficits will narrow over the next few years, the IMF still expects the US cyclically-adjusted primary budget deficit to be nearly 3% of GDP larger between 2022 and 2026 than it was between 2014 and 2019 (Chart 8). Chart 9The Fed And Investors Still Believe In Secular Stagnation As Matt Gertken, BCA’s Chief Geopolitical Strategist, writes in this week’s US Political Strategy report, the passage of the $550 billion infrastructure bill has increased, not decreased, the odds of President Biden and the Democrats passing their social spending bill via the partisan budget reconciliation process. On the monetary side, the Federal Reserve will finish tapering asset purchases next June and begin raising rates shortly thereafter. However, the Fed has no intention of raising rates aggressively. Most FOMC members see the Fed funds rate rising to only 2.5% this cycle (Chart 9). The “dots” call for only one rate hike in 2022 and three rate hikes in both 2023 and 2024. Investors expect rates to rise even less by end-2024 than the Fed foresees (Chart 10). The Inflation Outlook Hinges On The Slope Of The Aggregate Demand Curve If policy tightening will not suffice in cooling demand, the economy will overheat and inflation will rise. But by how much will inflation increase? The answer is of great importance to investors. It also hinges on a seemingly technical question: What is the slope of the aggregate demand curve? As Chart 11 illustrates, prices will rise more if the aggregate demand curve is steep than if it is flat. Chart 12Wages Rose Faster Than Prices During The Inflationary Late-60s and 70s It is tempting to think of the aggregate demand curve in the same way one might think of the demand curve for, say, apples. When the price of apples rises, there is both a substitution and an income effect. An increase in the price of apples will cause shoppers to substitute away from apples towards oranges. In addition, if apples are so-called “normal goods,” shoppers will buy fewer apples in response to lower real incomes. This chain of reasoning breaks down at the aggregate level. When economists say the price level has risen, they are referring to all prices; hence, there is no substitution effect. Moreover, since one person’s spending is another’s income, rising prices do not necessarily translate into lower overall real incomes. Granted, if nominal wages are sticky, as they usually are in the short run, an unanticipated increase in prices will reduce real wage income. However, this will be offset by higher business income. Over time, wages tend to catch up with prices. In fact, wage growth usually outstrips price growth during inflationary periods. For example, real wages rose during the late-1960s and 70s but fell during the disinflationary 1980s (Chart 12). Textbook Reasons For A Downward-Sloping Aggregate Demand Curve According to standard economic theory, there are three main reasons why aggregate demand curves are downward-sloping: The Pigou Effect: Higher prices erode the purchasing power of money, resulting in a negative wealth effect. The Keynes Effect: Higher prices reduce the real money supply. This pushes up real interest rates, leading to lower investment spending. The Mundell-Fleming Effect: Higher real rates push up the value of the currency, causing net exports to decline. None of these three factors are particularly important for the US these days. Chart 13Base Money Has Swollen Since The Subprime Crisis Strictly speaking, the Pigou wealth effect applies only to “base money,” also known as “outside money.” Outside money includes cash notes, coins, and bank reserves. Inside money such as bank deposits are not included in the Pigou effect because while an increase in consumer prices decreases the real value of bank deposits, it also decreases the real value of commercial bank liabilities.1 In the US, the monetary base has swollen from 6% of GDP in 2008 to 28% of GDP as a result of the Fed’s QE programs (Chart 13). Nevertheless, even if one were to generously assume a wealth effect of 10% from changes in monetary holdings, this would still imply that a 1% increase in consumer prices would reduce spending by only 0.03% of GDP. Simply put, the Pigou effect is just not all that big. In contrast to the Pigou effect, the Keynes effect has historically had a significant impact on the business cycle. However, the importance of the Keynes effect faded following the Global Financial Crisis as the Fed found itself up against the zero lower bound on interest rates. When interest rates are very low, there is little to distinguish money from bonds. Rather than holding money as a medium of exchange (i.e., for financing transactions), households and businesses end up holding money mainly as a store of wealth. In the presence of the zero bound, the demand for money becomes perfectly elastic with respect to the interest rate (Chart 14). As a result, changes in the real money supply have no effect on interest rates, and by extension, interest-rate sensitive spending. And if a decline in the real money supply does not push up interest rates, this undermines the Mundell-Fleming effect as well. Could The Aggregate Demand Curve Be Upward-Sloping? The discussion above, though rather theoretical in nature, highlights an important practical point: The aggregate demand curve may be quite steep. This means that the price level might need to rise a lot to equalize aggregate demand with aggregate supply. Chart 15US Real Bond Yields Hitting Record Lows In fact, one can easily envision a scenario where a rising price level boosts spending; that is, where the demand curve is not just steep but upward-sloping. One normally assumes that higher inflation will prompt central banks to raise rates by more than inflation has risen, leading to higher real rates. However, if the Fed drags its feet in hiking rates, as it is wont to do given its concerns about the zero bound, rising inflation will translate into a decline in real rates. Lower rates will boost demand, leading to higher inflation, and even lower real rates. In addition, lower real rates will benefit debtors, who tend to have a higher marginal propensity to spend than creditors. This, too, will also boost aggregate demand. It is striking in this regard that real bond yields hit a record low this week, with the 10-year TIPS yield falling to -1.17% and the 30-year yield drooping to -0.57% (Chart 15). Black Holes Vs. Supernovas In the case where the aggregate demand curve is upward-sloping, there is no stable equilibrium (Chart 16). If demand falls short of supply, demand will continue to shrink as the price level declines, leading to ever-rising unemployment. Unless policymakers intervene with stimulus, the economy will sink into a deflationary black hole. In contrast, if demand exceeds supply, demand will continue to rise as the price level increases exponentially. The economy will go supernova. Tick Tock Young stars fuse hydrogen into helium, releasing excess energy in the process. After the star has run out of hydrogen, if it is big enough, it will start fusing helium into heavier elements such as carbon and oxygen. The process of nucleosynthesis continues until it reaches iron. That is the end of the line. Fusing elements heavier than iron requires a net input of energy. Unable to generate enough external pressure through fusion, the star loses its battle to gravity. The core collapses, spewing material deep into interstellar space (a good thing since your body is mainly made from this stardust). Observing the star from afar, one would be hard-pressed to see anything abnormal until it explodes. The path to becoming a supernova is highly non-linear. The same is true for inflation. Just like a star with an ample supply of hydrogen, the Fed can burn through its credibility for a while longer. During the 1960s, it took four years for inflation to take off after the economy had reached full employment (Chart 17). By that time, the unemployment rate was two percentage points below NAIRU. Most of today’s inflation is confined to durable goods. This is not a sustainable source of inflation. The durable goods sector is the only part of the CPI where prices usually fall over time (Chart 18). Chart 17Inflation Spiked In The 1960s Only Once The Unemployment Rate Had Fallen Far Below Equilibrium Chart 18Inflation Has Been Concentrated In Durable Goods, A Sector Where Prices Usually Fall Over Time To get inflation to go up and stay up in modern service-based economies, wages need to rise briskly. While US wage growth has picked up, the bulk of the increase has been among low-wage workers, particularly in the services and hospitality sector (Chart 19). Chart 19Wage Growth Has Picked Up, But Mainly At The Bottom Of The Income Distribution The most likely scenario for next year is that firms will simply ration output, fearful that raising prices too quickly will hurt brand loyalty and trigger accusations of price gouging. Shortages will persist, but this time they will be increasingly concentrated in the service sector. Such a state of affairs will not last, however. Competition for workers will cause wages to rise much more than they have so far. Keen to protect profit margins, firms will start jacking up prices. A wage-price spiral will develop. The US economy could go supernova. Investment Conclusions Chart 20Long-Term Inflation Expectations Are Near The Bottom End Of The Fed's Comfort Zone US growth will slow next year, not because demand will falter, but because supply-side constraints will prevent the economy from producing as much output as households and businesses want to buy. This means that the old playbook for dealing with growth slowdowns needs to be thrown out the window. Rather than positioning for lower bond yields, investors should position for higher yields. Rather than expecting a stronger dollar, investors should expect a weaker one. Rather than favoring growth stocks, large caps, and defensives, investors should favor value stocks, small caps, and cyclicals. While inflation expectations have recovered from their pandemic lows, the 5-year/5-year forward TIPS breakeven inflation rate is still near the bottom end of the Fed’s comfort zone (Chart 20). Rising inflation expectations will lift long-term bond yields, justifying a short duration stance in fixed-income portfolios. Higher bond yields will benefit value stocks. Chart 21 shows that there has been a strong correlation between the relative performance of growth and value stocks and the 30-year bond yield this year. Rising input prices will make the US export sector less competitive, leading to a weaker dollar. Historically, non-US stocks have done well when the dollar has been weakening (Chart 22). Chart 21The Relative Performance of Value Stocks Has Closely Tracked Bond Yields This Year Chart 22Non-US Stocks Tend To Do Best When The US Dollar Is Weakening As for the overall stock market, with the Fed still in the dovish camp, it is too early to turn negative on equities. An equity bear market is coming, but not until rising inflation forces the Fed to step up the pace of rate hikes. That will probably not happen until mid-2023. Short Gilt Trade Activated We noted last week that we would go short the 10-year UK Gilt if the yield broke below 0.85%. Our limit order was activated on November 5th and we are now short this security. Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Footnotes 1 To distinguish between inside and outside money, one should ask where the liability resides. If the liability resides within the private sector, it is inside money. By convention, central bank reserves are classified as outside money. However, one could argue that since taxpayers ultimately own the central bank, an increase in the price level will benefit taxpayers by eroding the real value of the central bank’s liability. If one were to take this view, the Pigou effect would be even weaker. 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Dear client, This week, we are introducing our new “Currency Month-In-Review” report. The new format should dovetail nicely with the historical back sections you have become accustomed to, but with a more holistic approach to interpreting data releases, along with actionable investment advice. We would appreciate any comments, criticisms, and feedback to help us better serve you. Kind regards, The Foreign Exchange Strategy team Highlights The DXY index has broken above our 95-threshold level. As a momentum currency, the prospect for further gains in the near term are high. That said, we are sticking with our longer-term (12-18 month) bearish view. Most of the catalysts propping the dollar in the near-term should reverse. The Fed will continue to lag the inflation curve, and economic growth will rotate from the US to other economies that are getting their populations vaccinated. Both are dollar bearish. Speculative positioning in the dollar is now approaching extremes. This warns against establishing fresh long positions. Amidst the volatility in currency markets, trading opportunities are emerging. This week, we are initiating a limit-buy on EUR/CHF trade at 1.05. Feature The latest CPI report from the US was strong, taking markets much by surprise. In the currency world, the spread between the 3-month Eurodollar and Euribor interest rate shot up, pushing up the dollar (Chart 1). December 2022 Eurodollar futures are now pricing in a much faster pace of rate hikes than they did earlier this year. This helped cement the dollar as king this year (Chart 2). Chart 1The Dollar And Interest Rates Chart 2AThe Strength In The DXY Is Not Fully Justified By The Economic Picture Chart 2BThe Strength In The DXY Is Not Fully Justified By The Economic Picture Chart 2CThe Strength In The DXY Is Not Fully Justified By The Economic Picture Chart 2DThe Strength In The DXY Is Not Fully Justified By The Economic Picture Economic data has also been moving in favor of the US of late. The economic surprise index in the US is at 19, while in the eurozone and Japan, it is at -50 and -73.9, respectively. From a broader perspective, the recovery in the services PMI in the US had been more robust than most other developed economies. That said, there are also signs that US economic momentum is giving way to other countries. The US is likely to be the first country to close its output gap, and commensurately, inflation is surprising to the upside (Chart 3). Wage growth has also inflected higher. This is raising the prospect that inflation might be more of a genuine concern. For many other countries, surging house prices are threatening financial stability. In New Zealand, the central bank now has a mandate to consider house prices when calibrating policy. Chart 3AThe US Is Generating Genuine Inflation. This Is Depressing Real Rates Chart 3BThe US Is Generating Genuine Inflation. This Is Depressing Real Rates Chart 3CThe US Is Generating Genuine Inflation. This Is Depressing Real Rates Chart 3DThe US Is Generating Genuine Inflation. This Is Depressing Real Rates The key point is that many central banks have already withdrawn accommodation ahead of the Fed, which puts the recent dollar rally into question. QE has ended in Canada and New Zealand. Norway and New Zealand have hiked interest rates. Forward curves suggest that most central banks should continue to withdraw accommodation. The key question is whether the Fed turns more hawkish that what is already priced in, or disappoints market expectations. We side with the latter. In the meantime, real rates continue to remain deeply negative in the US. With negative real rates and a deteriorating trade balance, the US will need to significantly raise interest rates to attract portfolio investment. For the US, portfolio investment has mostly been in the form of equity purchases rather than bond flows (Chart 4) and Chart 5). But even an increase in the US 10-year yield to 2.25% will keep real interest rates low. In the following sections, we look at the latest economic releases and provide our assessment of the impact going forward on various currencies. Chart 4AThe Fed Could Disappoint Market Expectations Chart 4BThe Fed Could Disappoint Market Expectations Chart 4CThe Fed Could Disappoint Market Expectations Chart 5AThe US Trade Deficit Needs To Be Financed Externally Chart 5BThe US Trade Deficit Needs To Be Financed Externally Chart 5CThe US Trade Deficit Needs To Be Financed Externally Chart 5DThe US Trade Deficit Needs To Be Financed Externally US Dollar The last month has seen US economic data outperform that of its peers. Within the G10, the Citigroup economic surprise index is much higher in the US (+19), than say, the euro area (-50) or Japan (-74). This has supported the DXY, which is up almost 1% over the last month. For risk-management purposes, we are turning neutral on the DXY in the near term, even though our longer-term view remains bearish. The two most important releases in the US over the last month were the jobs report and this week’s CPI report. Nonfarm payrolls increased by 531,000 jobs and unemployment fell to 4.6% in October. This is inching closer to NAIRU. Meanwhile, headline CPI came in at 6.2% year-on-year in September while core inflation came in at 4.9%, the highest for several decades. This is occurring within the context of accelerating wage growth (unit labor costs in the nonfarm business sector surged 8.3% in Q3), higher house prices, and an ebullient stock market, reinforcing the wealth effect. That said, strong domestic demand in the US will have to trigger a much more hawkish Fed for the dollar to reach escape velocity. This is because it will push real interest rates lower as it inflates the US current account deficit. The trade deficit grew 11.2% in September, the sharpest monthly increase since July of 2020. Equity portfolio flows, which have been sustaining the trade deficit, are softening of late. Bond portfolio flows will need a much weaker dollar, or higher Treasury yields, to accelerate. Against such a backdrop, the Fed recently announced a “dovish taper” by reducing the monthly pace of its asset purchases by $15 billion, with the tapering expected to be completed by mid-2022. No imminent rate hike was signaled. The market is likely to continue to challenge such a dovish stance, which will put near-term upward pressure on the dollar, until inflation eventually rolls over. From a relative standpoint, the Fed is lagging many other major developed market central banks in normalizing monetary policy. We are sticking to our long-term bearish view on the dollar index, but a more proactive Fed is a risk to this view. We are upgrading our near-term outlook on the dollar to neutral. Chart 6AUS Dollar Chart 6BUS Dollar Euro The euro has been breaking down in recent sessions and is the main cause of the surge in the DXY index. The euro is down 0.7% over the last month and is currently at 1.145. The key catalyst for the weakness in the euro is the perception that the ECB will severely lag the Fed in normalizing policy settings. This is occurring within the context of surging inflation in the euro area. Headline CPI came in at 4.1% in October, above expectations of 3.7% and well above September’s 3.4% print. The is dampening real rates in the entire eurozone. On the flip side, there is credence to the ECB’s dovish stance given that unemployment is still above NAIRU and eurozone wage growth remains very tepid. On the economy, the recent improvement in both the Sentix and ZEW expectations bode well for euro area activity. Lower real rates have been the proximate driver of a soft euro in recent trading sessions. That said, real rates could improve if inflation proves transitory. The energy component of the CPI was up 23% year-on-year, by far the biggest contributor to the headline print. Any sign that the ECB is tilting towards a more hawkish direction will initially materialize in the form of reduced asset purchases. This would curtail the significant portfolio outflows from the eurozone this year. From a positioning standpoint, speculative long positions in the euro have also been liquidated, which provides some footing for the currency. We are maintaining a neutral stance on the euro in the very near term, with a bias to buy on weakness. Chart 7AEuro Chart 7BEuro Japanese Yen JPY is the worst-performing currency this year and it is also one of the most shorted. Over the last month, the yen is down 0.4%. Japan is just now emerging from the pandemic, having vaccinated most of its population. Ergo, the economic surprise index, which currently sits at -74, could stage a powerful rebound. While both the inflation print and employment data were in line with expectations (the unemployment rate came in at 2.8% in September), there were other encouraging signs. In October, the Eco Watcher’s Survey rose from 42.1 to 55.5, the manufacturing PMI rose from 51.5 to 53.2, and machine tool orders accelerated 81.5% year-on-year. The Bank of Japan kept monetary policy unchanged at its latest meeting. The policy stance of the BoJ remains dovish, with little prospect of any interest rate increase until 2025. Therefore, in an environment where interest rates rise, that will hurt the yen at the margin. That said, the underperformance of Japanese assets is attracting portfolio inflows, especially from equity investors. As we wrote last week, the underperformance of certain Japanese equity sectors has not been fully justified by the improving earnings picture. From a valuation standpoint, the yen is the cheapest G10 currency according to our PPP models, and it is also quite cheap according to our intermediate-term timing model. Therefore, even given the breakout in the DXY index, we are maintaining our near-term positive for the yen. Chart 8AJapanese Yen Chart 8BJapanese Yen British Pound As a high-beta currency, sterling has been one of the victims of dollar strength. GBP is down 1.6% over the last month. The biggest driver was the volte-face from the BoE. The BoE kept rates on hold despite their seemingly hawkish messaging weeks ahead of the MPC meeting. Gilt yields fell along with the pound. Following the expiry of the furlough scheme in September, the central bank is waiting to the see the potential impact on the labor market before curtailing accommodation. Hence, a hike in December is still on the table. Incoming data continues to strengthen the case for the BoE to tighten policy. CPI is at 3.5%, with the transport and housing sectors continuing to see surging prices. At 4.5%, the unemployment rate is at NAIRU. Wages are also inflecting higher. The latest GDP report (Q3 GDP rose 6.6% year-on-year) continues to suggest the UK economy maintains upward momentum. The October manufacturing PMI rose from 57.1 to 57.8. Near term, the pound could continue to face weakness as speculators liquidate positions and capital inflows soften. This is especially the case as the post-Brexit environment remains quite volatile. As a play on this trend, we are tactically long EUR/GBP. However, we remain bullish sterling on a cyclical horizon as real rates should continue to normalize. Chart 9ABritish Pound Chart 9BBritish Pound Australian Dollar The Australian dollar is down 0.8% over the last month, as both a stronger dollar and lower iron ore prices exert downward pressure on the exchange rate. The biggest developments over the last few weeks in Australia were the CPI report and the RBA policy meeting. The Q3 print for CPI was 3%, the upper bound of the central bank’s target range, with the trimmed-mean and weighted-median figure coming in at 2.1%. This helped justify the RBA’s decision to abandon the 0.1% yield target on the April 2024 bond. That said, the central bank maintained its cash rate target of 0.1% until earliest 2023 and left the pace of asset purchases unchanged. The RBA trimmed its forecast for GDP for this year to 3% from 4% and said more than 50% of jobs were currently experiencing little to no wage growth. Wages grew just 1.7% in the year to June, far below the 3%-plus levels the RBA believes is necessary to keep inflation sustainably within the 2%-3% band and trigger a rate hike. Hence, the release of the Q3 wage price index, on November 17, will be closely watched. Any upward surprise can challenge the RBA’s measured projections. The bearish case for the Aussie is well known, with speculative positioning near a record short. That said, real yields in Australia have been improving and portfolio flows are accelerating, especially into the mining and energy sectors, which are benefiting from a terms-of-trade tailwind. This sets the stage for a coil-spring rebound in the Aussie. Meanwhile, the AUD is cheap, especially on a terms-of-trade basis. At the crosses, we are long AUD/NZD as a play on these trends. From a tactical standpoint, we are neutral the Aussie, but will buy outright at 70 cents. Chart 10AAustralian Dollar Chart 10BAustralian Dollar New Zealand Dollar The New Zealand dollar is up 1.3% over the last month. New Zealand’s economy is firing on all cylinders. CPI accelerated sharply from 3.3% to 4.9% in Q3, well above the RBNZ’s target band of 1%-3%, and behind only that of the US. The unemployment rate fell to 3.4% in Q3, far lower than the 3.9% forecasted by economists polled by Reuters. Wage growth was strong in the quarter with the private sector labor cost index registering a 0.7% lift. The seasonally adjusted employment number jumped 2.0% on the quarter, beating expectations of a 0.4% increase. The participation rate also rose to 71.2%, higher than the 70.6% forecast. Meanwhile, house prices continue to move higher, especially in Wellington. As a result, the RBNZ has been one of the most hawkish G10 central banks, hiking rates last month for the first time in seven years to 0.5%. Another 0.25% hike is likely at the November 24 meeting. Meanwhile, at 2.6%, New Zealand currently has the highest G10 10-year bond yield. This is bullish for the kiwi. The one caveat is that the Covid-19 situation in New Zealand continues to deteriorate, which could be a catalyst for a pause. Portfolio flows into New Zealand have turned negative in recent quarters. The equity market, which is quite expensive, has underperformed and the currency is overvalued according to our models, which has dampened the appeal of higher yields. We continue to believe the NZD will fare well cyclically, but hawkish expectations from the RBNZ are already priced in. This provides room for disappointment. Chart 11ANew Zealand Dollar Chart 11BNew Zealand Dollar Canadian Dollar The CAD is the best-performing currency this year, even though it is down 1% over the last month. The key driver of the CAD in recent weeks remains the outlook for monetary policy, and the path of energy prices. CPI inflation came in at 4.4% year-on-year for September, beating market expectations and among the highest across the G10. The CPI-trim hit 3.4% year-on-year. With all eight major components of the CPI rising year-over-year, upward price pressures are broad-based. The housing market also appears bubbly, all providing fertile ground for tighter monetary settings. At first blush, the October employment report was disappointing, with only 31,000 jobs added. However, employment in Canada is already above pre-pandemic levels and is likely to now settle towards trend growth of around 2%. This suggests a print of 30,000 - 40,000 jobs, in line with October’s release. The unemployment rate continues to drop, hitting 6.7%. Incoming data justified the Bank of Canada’s policy response. It delivered a hawkish surprise announcing an end to its quantitative easing program and shifting to the reinvestment phase whereby its holdings of Canadian government bonds will be held constant. It also brought forward the first rate hike to Q2 2022. The BoC will marginally diverge from the US Fed, which is expected to keep rates unchanged through most of next year. This will continue to boost real rates in Canada. Meanwhile, net purchases of Canadian securities continue to inflect higher, as the commodity sector benefits from a terms-of-trade boom. That said, from a tactical standpoint, speculators are marginally long the CAD. As such, our near-term view is cautious. We however doubt the CAD will significantly break below 78 cents, given burgeoning tailwinds. Chart 12ACanadian Dollar Chart 12BCanadian Dollar Swiss Franc The Swiss franc is up 1% against the dollar over the last month. EUR/CHF has also been very weak in recent trading sessions, constantly testing the 1.054 level. In our view, this has been much more due to euro weakness (see euro section above) than franc strength. The Swiss franc is trading near 11-month highs versus the euro. On the economic front, the labor market is improving and inflation in Switzerland is picking up. House prices have also risen quite robustly. This is lessening the need for the central back to maintain ultra-accommodative settings. That said, the Swiss National Bank is likely to lag the rest of the G10 in lifting rates from -0.75%, currently the lowest benchmark interest rate in the world. This suggests that market pricing of a 25 basis-point rate rise by the SNB by the end of 2022 is misplaced. Inflation would have to rise substantially more - above the SNB's target range of less than 2% - before any hike is possible. The SNB has also said it remained ready to intervene to weaken a highly valued Swiss franc. The ECB’s dovish stance is one reason why the SNB will be loath to let the currency appreciate. Our guess is that the 1.05 level provides a near-term line in the sand, which will prompt the SNB to intervene. We would be buyers of EUR/CHF below 1.05. Chart 13ASwiss Franc Chart 13BSwiss Franc Norwegian Krone The Norwegian krone has violently sold off in recent weeks, prompting our long Scandinavian basket to be stopped out. This has been mostly due to low liquidity and the high-beta nature of the krone. Norway’s central bank kept interest rates on hold at its latest meeting but reiterated it will likely hike its key rate by 25 basis points to 0.5% in December. The central bank noted that the economic recovery pushed activity back to pre-pandemic levels, while unemployment receded further. That said, underlying inflation still runs below the bank’s target. The recent surge in oil prices has provided strong support for Norway’s trade balance and terms of trade. Oil and gas make up around 18% of Norway’s GDP. This is encouraging portfolio flows and has provided underlying support for the NOK. That said, given that much of the Norges Bank’s hawkishness has likely been priced into the NOK, the rewards of going long the currency should start shifting to its carry. Chart 14ANorwegian Krone Chart 14BNorwegian Krone Swedish Krona The SEK was up 0.9% over the last month. Sweden never closed its economy, yet Covid-19 still had an impact. The good news is that this is mostly behind them. GDP expanded by 1.8% on the quarter in Q3, beating forecasts and the country recently ended all pandemic curbs. The labor market is recovering, and inflation is rising. CPIF inflation, on which the Riksbank sets its 2% target, is at 2.8%. Surging energy prices should turn out to be less of a problem for Sweden than the more coal-dependent countries in Europe, suggesting any increase in prices will be more genuine. The Riksbank will complete its planned balance-sheet expansion later this year and has committed to maintaining the size of its bond holdings through 2022. The central bank, one of the most dovish amongst the G10, is slated to keep its policy rate flat at least until 2024. This could change if inflationary pressures remain persistent. The big risk for Sweden is a slowdown in Europe and China. Supply chain bottlenecks are another issue. Several Swedish car and truck makers were forced to halt production in August due to semiconductor shortages. With the recent surge in the dollar, we were stopped out of our short EUR/SEK and USD/SEK positions for a profit. We will be looking to reinstate these trades from higher levels. Chart 15ASwedish Krona Chart 15BSwedish Krona Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Kate Sun Research Analyst kate.sun@bcaresearch.com Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary