Fixed Income
Highlights Growth Scare: Despite the recent pickup in global equity market volatility, bond volatility remains subdued. Until there is more decisive evidence of a deeper pullback in global growth that is impacting the mighty U.S. economy, yields on government bonds - which remain overvalued in all major developed economies - will have difficulty falling much more even if equity markets continue to correct. Stay below benchmark on global duration exposure, while maintaining only a neutral allocation to global credit. Canada: The Bank of Canada remains on a hawkish path to a more neutral policy rate, even with the lingering concerns over household debt and global trade tensions. Stay underweight Canadian government bonds in hedged global bond portfolios. Feature Just like that other great October tradition, Halloween, market volatility has returned to spook investors. Both the MSCI All-Country World Index and S&P 500 index are officially in correction territory, down -10% from the highs reached in September. The causes for the pullback range from high-profile third quarter U.S. earnings disappointments to increased evidence that the U.S.-China tariff war is negatively impacting U.S. investment spending. Yet the reaction from global bond markets has been relatively muted for such a large pullback in stocks. Benchmark 10-year government bond yields for the major developed markets are down from their peaks, but the declines have been smaller in countries where central banks are in a rate hiking cycle (U.S. -14bps, Canada -19bps) relative to countries where central banks are on hold (Germany -20bps, U.K. -31bps). One possible reason for this discrepancy is that the downtrend in data surprises appears to have stabilized in the U.S. and, even more importantly, China, while European data continues to disappoint relative to expectations (Chart of the Week). Chart of the WeekNoisy Equities, Calm Bonds We still do not believe that global bond yields have peaked for the cycle. We continue to recommend a below-benchmark strategic bias on overall duration exposure, but with only a neutral allocation to global corporate bonds that favors U.S. credit. On a more shorter-term tactical basis, there is a risk that yields could decline further, with more credit spread widening than seen during the current risk-off episode, if economic data starts to disappoint in the U.S. where growth has so far been resilient. Staying up in credit quality within an allocation to U.S. corporates is one way to hedge against such an outcome. Bond Yields Are Normalizing, Bond Volatility Is Not The selloff in risk assets has resulted in a pickup in widely-followed market volatility measures like the U.S. VIX index. Yet when looking at the level of realized total return volatility across all major asset classes, the current bout of turbulence has been unimpressive outside of global equities. In Chart 2, we present an update of a chart from our 2018 global bond outlook report, showing the current levels of realized volatility across different asset class benchmarks compared to their historical ranges. The vertical lines in each chart represent the range between 1999 and 2017 of annualized monthly volatilities for global government bonds, credit, equities, currencies and commodities. The red triangles represent the most recent 13-week annualized volatilities for those same asset classes. What stands out in the chart is that volatilities are off the historical lows for global equities, Italian government bonds and industrial commodities, yet volatilities remain subdued for developed market government bonds, global corporate debt and currencies. Chart 2Bond Volatility Remains Subdued, Despite More Volatile Equities We have long argued that the shift to a structurally higher level of volatility across all asset classes will show up first with a rise in bond volatility. In the U.S., in particular, sustained periods of elevated volatility for both Treasuries (as measured by the MOVE index) and stocks (as measured by the VIX index) have occurred alongside episodes of greater variance in nominal GDP growth (Chart 3). When the latter rises, that also triggers more uncertainty about the future path of monetary policy which feeds into a rise in expected bond volatility. That, in turn, impacts volatility in growth sensitive assets like equities, credit and commodities. Chart 3Equity Vol Responding To Growth Uncertainty Right now, nominal GDP volatility has picked up in the U.S. but still remains low by historical standards (middle panel). Some of that increased growth volatility can be attributed to the Trump fiscal stimulus coming at a time of full employment, which has helped boost both real GDP growth and U.S. inflation. Interest rate markets have moved to discount more Fed hikes in response, but the Fed's steady pace of well-telegraphed, 25bps-per-quarter rate increases is likely acting to dampen Treasury market volatility. As we have written about extensively throughout the course of 2018, the hurdle for central banks (not just the Fed) to shift to a less hawkish or more dovish policy stance is much higher when unemployment is low and inflation is closer to central bank targets. In such an environment, the correlation between equity and bond returns should be weaker than during periods of excess capacity and low inflation when central banks can stay dovish. That can be seen in Chart 4, which plots the trailing 52-week correlation of total returns for equities and government bonds for the major developed markets (top panel), along with the 10-year market-based inflation expectations for each country (bottom panel). For almost all countries shown, the stock/bond correlation has risen to zero away from the negative correlations that dominated the post-crisis years. That move in correlations has occurred alongside a more stable backdrop for inflation expectations, which are much closer to central bank targets. The lone exception is, of course, Japan, where inflation remains disappointingly low and the Bank of Japan continues to keep a tight lid on interest rates. Chart 4More Stable Inflation Means Less Correlated Stock & Bond Returns Besides more stable inflation, another factor preventing yields from falling as much as implied by the declines in equity markets is that global bond yields remain overvalued relative to trend economic growth. One way to assess this is to look at the level of real bond yields relative to a moving average of actual GDP growth. We show this for the major developed economies in Charts 5 & 6, which plot rolling 3-year moving averages of real GDP growth (a proxy for "trend" or potential growth) versus real 5-year government bond yields, 5-years forward. For the latter, we take the nominal 5-year/5-year forward yield and subtract a five-year moving average of realized headline inflation for each country, rather than market-based inflation-linked instruments like CPI swaps or TIPS, to allow for a longer history of real yields in the charts. Chart 5Real Bond Yields Are Still Too Low ... Chart 6... Compared To Real Economic Growth For all countries show, real bond yields remain below the level of real growth. The gap between the two is smallest in the U.S. and Canada - unsurprising, as central bankers have been tightening monetary policy, and helping push up real interest rates, in both countries. Bonds look most overvalued in core Europe, Japan and Sweden where policymakers have been using negative interest rates and quantitative easing (QE) to hold down bond yields. Real yields in those countries are between 200-300bps below our proxy for trend real growth. With such a large gap between actual growth and interest rates, it becomes harder for policymakers to consider easing monetary policy, or at least slow the pace of policy normalization, in response to more volatile financial markets. It should not be a surprise that last week, during a period of global market turmoil, the European Central Bank and Sweden's Riksbank both signaled that they remain on pace to end QE and begin hiking interest rates within the next 6-12 months, while the Bank of Canada delivered another 25bp rate hike. In the absence of a VERY large global growth shock, global real yields should be expected to increase over at least the next year, and a defensive posture on global duration exposure should be maintained. One such shock could come from a deeper downturn in China than has already occurred in 2018, which would feed into a bigger slowdown in non-U.S. growth. Another shock could come from the U.S. if the recent pullback in core durable goods orders (Chart 7) is a sign that a) U.S. companies are becoming more worried about the impact of U.S.-China trade tariffs on global growth; and/or b) the impact of the Trump fiscal stimulus is already starting to fade. Such a move could be exacerbated by a larger downturn in housing activity than seen already in response to rising mortgage rates. Chart 7Treasuries Are Exposed To A U.S. Growth Scare These shocks, if large enough, could trigger a short-covering rally in U.S. Treasuries, where sentiment remains very depressed (bottom panel). However, with leading economic indicators still pointing to above trend U.S. growth, and with U.S. consumer spending holding firm alongside a tight labor market and faster wage growth, such a pullback in yields would likely be short-lived and difficult for investors to time successfully. Bottom Line: Despite the recent pickup in global equity market volatility, bond volatility remains subdued. Until there is more decisive evidence of a deeper pullback in global growth that is impacting the mighty U.S. economy, yields on government bonds - which remain overvalued in all major developed economies - will have difficulty falling much more even if equity markets continue to correct. Stay below benchmark on global duration exposure, while maintaining only a neutral allocation to global credit. Canada Update: The BoC Stays Hawkish The Bank of Canada (BoC) delivered another rate hike last week, lifting the policy rate by 25bps to 1.75%. The language used to explain the hike was surprisingly hawkish. In the press conference following the BoC meeting, Senior Deputy Governor Carolyn Wilkins noted that the policy rate remains negative in real terms and is still below the central bank's estimate of neutral (between 2.5% and 3.5%). She also noted that the term "gradual" was no longer used to describe the pace of monetary tightening, so as not to give the impression that policy was following a steady predetermined path similar to the Fed's tightening cycle - potentially, a sign that more hawkish surprises could be in the offing. The BoC also sounded more optimistic on the outlook for the Canadian economy, while sounding less concerned about the two factors that should cause the most worry - high consumer debt levels and uncertainty over global trade. The more upbeat tone is at odds with the current pace of economic growth in Canada, which has slowed. GDP growth has decelerated to 1.9% from 3.0% at the end of 2017, while the OECD's leading economic indicator for Canada is also in a downtrend (Chart 8). In the Monetary Policy Report (MPR) that was also released last week, the latest BoC forecasts for Canadian real GDP growth for 2019 and 2020 were essentially left unchanged. Chart 8Is The BoC's Growth Optimism Justified? The BoC noted that the composition of demand within the Canadian economy was shifting away from consumption and housing towards business investment and exports. That can be seen in the most recent data that shows sluggish consumer spending (middle panel) and rebounding export growth (bottom panel). The central bank attributes the softer path for consumption to its own interest rate increases and changes to housing market policies, both of which have forced households to adjust their spending patterns. That is evident in the sharp decline in house price growth, deceleration of household credit growth and the softening trends in housing starts and residential investment spending (Chart 9) Chart 9Canadian Housing Has Cooled Off The BoC is of the view, however, that consumer spending will rebound (but not overheat) on the back of strong household income growth and a pickup in net immigration inflows that is boosting population growth. The other area of diminished concern for the central bank is investment spending, which has been negatively impacted by the uncertainty over the renegotiation of the North America Free Trade Agreement (NAFTA). That smooth acronym is now gone, to be replaced by the more awkward "USMCA", or United States-Mexico-Canada Agreement. That new trade deal has reduced the immediate uncertainty over the impact of U.S. trade policy on Canada, although the BoC did note in the MPR that there was still the potential for lingering uncertainty based on previous U.S. trade actions (i.e. on steel and aluminum imports to the U.S.) and because the USMCA has not yet been ratified. The BoC did make an upward adjustment to its assumptions regarding the hit to Canadian growth from U.S. trade policy compared to the July MPR. The level of exports is now only expected to fall by -0.3% over the next two years (vs -0.7% in the July MPR) and business investment is expected to decline by -0.7% over the same period (vs -1.4% in the July MPR). The reduction in trade uncertainty should be expected to free up demand for capex in Canada. The Q3/2018 BoC Senior Loan Officers' Survey reported a further easing of lending standards from the Q2 survey (Chart 10). The central bank's Q3 Business Outlook Survey also noted that firms' investment intentions continued to strengthen to the highest level in eight years (middle panel). This was primarily due to increased expectations for future sales growth, coming at a time of high reported capacity pressures (bottom panel). Importantly, the Business Outlook Survey took place before the USMCA deal was reached, suggesting that the data may actually understate sales expectations. This bodes well for future gains to overall GDP growth from business investment spending. Chart 10Canadian Companies Need To Invest & Hire That same Business Outlook Survey also reported that firms are continuing to experience labor shortages, most notably in sectors such as construction, transportation and information technology. This is a sign that employment growth should remain firm in Canada. Coming at a time when the unemployment rate at 5.9% remains well below estimates of full employment, this suggests that there could be some upward pressure on inflation. Canadian headline CPI inflation currently sits at 2.2%, while core CPI inflation is at 1.8% (Chart 11). That is a sharp decline from the 3% inflation seen in July, which was the result of an unexpected surge in airline fares. Yet at current levels, Canadian inflation sits right at the midpoint of the BoC's 1-3% target range. Furthermore, the BoC's own assessment is that the output gap is in a range of -0.5% to +0.5%, in line with the estimates from the IMF and OECD (middle panel). Although headline wage growth has cooled in recent months, the BoC's preferred measure that incorporates several wage measures ("Wage-Common"), has been stable near the same 2% levels as seen for CPI inflation. Chart 11Canadian Inflation At BoC Target Expect More BoC Hikes With the Canadian economy operating at full employment and with inflation at target, the BoC seems determined to push the policy rate back up towards their estimated 2.5%-3.5% range for the neutral rate. This means another 75-175bps of additional rate increases. At the moment, there are only 49bps of hikes over the next year discounted in the Canadian Overnight Index Swap (OIS) curve (Chart 12). This leaves Canadian bond yields exposed to additional rate increases. This is especially true given our forecast of continued Fed interest rate increases in 2019, as the BoC has been playing a game of "Follow the Leader" with the Fed during the current tightening cycle (top panel). Chart 12Stay Underweight Canadian Government Bonds In terms of our recommended fixed income investment strategy, we continue to favor: an underweight stance on Canadian government bonds for global bond investors a below-benchmark duration stance within dedicated Canadian bond portfolios long positions in Canadian inflation protection (CPI swaps or inflation-linked bonds) While we expect the Canadian yield curve to flatten as the BoC delivers more rate hikes than currently discounted over the next year, we do not see the 2-year/10-year curve flattening by more than is currently priced in the forwards. This is not the case for an outright duration bet, where the forwards are currently priced for very little upward movement in Canadian bond yields over the next year. Therefore, we prefer to stick with directional bets on Canadian yields (higher) and Canadian relative bond performance versus global peers (worse). Bottom Line: The Bank of Canada remains on a hawkish path to a more neutral policy rate, even with the lingering concerns over household debt and global trade tensions. Stay underweight Canadian government bonds in hedged global bond portfolios. Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, CFA, Research Analyst ray@bcaresearch.com Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights Duration: The current strength of the U.S. economy suggests that, as was the case in February, the sell-off in risk assets may not result in much of a drop in Treasury yields. Weak foreign economic growth still presents a risk, but it should be hedged by adopting a more defensive stance on credit, not by increasing portfolio duration. Corporate Bonds: Weak foreign economic growth will impact U.S. corporate profits and investment spending before hitting U.S. consumer spending and overall GDP. This means it is better to hedge the risk from weak foreign growth by scaling back exposure to corporate bonds, while maintaining below-benchmark duration. Credit Curve: Favoring the long-end of the credit curve is a way to increase the average spread of a bond portfolio without taking on extra credit risk. Rather, the long-end of the credit curve outperforms when Treasury yields rise and underperforms when they fall. In the current environment we prefer going after the extra spread at the long-end of the credit curve, while maintaining an up-in-quality bias and only a neutral allocation to corporate bonds. Feature We're not out of the woods yet. Risk assets continued their decline last week, the VIX remains elevated and the 10-year yield has fallen off its highs (Chart 1). In the context of our Fed Policy Loop, lower bond yields are a positive sign for risk assets. Chart 1How Much Worse Will It Get? In our Fed Policy Loop framework, higher yields and the perception of increasingly hawkish Fed policy cause credit spreads to widen and stock prices to fall. Then, tighter financial conditions eventually lead to perceptions of more dovish Fed policy and lower bond yields. At some point, yields fall far enough to put a floor under risk assets (Chart 2). Chart 2The Fed Policy Loop We are now at the stage of the loop where we must determine how large a decline in Treasury yields will be necessary to halt the slide in risk assets. To make that determination, it is helpful to think about why risk assets are falling. Is it a simple correction driven by investors re-assessing appropriate valuations? Or is the market sniffing out a future slowdown in economic growth? Chart 3 shows why the difference is meaningful. In February 2018, a sharp increase in Treasury yields caused the stock-to-bond total return ratio to decline. However, the ratio quickly recovered once investor sentiment toward the stock market became somewhat less bullish. Importantly, Treasury yields did not need to fall to support a rebound in risk assets, they only needed to level-off for a time. Chart 3Lower Yields Required? In contrast, a meaningful decline in Treasury yields was required to arrest the drop in the stock-bond ratio that occurred in late-2015/early-2016. The difference between that period and the February 2018 period is obvious. In late-2015/early-2016, the U.S. Manufacturing PMI had just dipped below the 50 boom/bust line. This year the PMI has been closer to 60 (Chart 3, bottom panel). The current strength of the U.S. economy suggests that, as was the case in February, the sell-off in risk assets may not result in much of a drop in Treasury yields. With the market only priced for 54 bps of rate hikes during the next 12 months, and no signs of softening in the U.S. economic data, we are reluctant to abandon our cyclical below-benchmark portfolio duration stance at this time. That is not to say there are no risks on the horizon. In past reports we flagged the risk that slowing foreign economic growth will eventually impact the U.S. economy, causing it to slow as we head into next year.1 However, we think it makes more sense to hedge this risk by adopting a more defensive allocation to corporate credit versus Treasuries, rather than by shifting portfolio duration to look for lower yields. Hedge Economic Risk In Credit, Not Duration As was stated above, U.S. economic growth remains strong and the biggest risk on the horizon is that weak foreign growth eventually migrates stateside via a stronger dollar. Last week's third quarter GDP report confirmed that overall growth is solid, but also showed some evidence of weak foreign growth impacting the U.S. figures. Overall, real GDP grew by a healthy 3.5% (annualized) in the third quarter, supported mostly by consumer spending which contributed 2.7% to overall growth, the most since Q4 2014 (Chart 4). However, weakness was found in nonresidential investment spending which contributed only 0.1% to real growth, down from 1.2% in the prior quarter (Chart 4, bottom panel). Chart 4Parallels With Early 2015 This distribution of growth between consumer spending and investment is identical to what occurred in 2015, the last time that weak foreign growth infiltrated the U.S. economy. The more globally-exposed investment sector contributed almost nothing to growth in the first two quarters of 2015, while overall GDP growth stayed elevated, driven by strong consumer spending. Eventually, consumer spending also weakened and GDP growth plunged in the second half of the year, but the warning sign that weak foreign growth was negatively impacting the U.S. economy came from investment spending in the first half of 2015. We draw the distinction between U.S. investment spending and U.S. consumer spending for two reasons. The first is that investment spending is more influenced by global factors than the U.S. consumer. The second is that investment spending is tightly linked to corporate profit growth (Chart 5). In other words, weak foreign economic growth is likely to negatively impact U.S. corporate profits before it hits overall U.S. GDP. This makes credit spreads more exposed to global weakness than Treasury yields, which take their cues from overall GDP growth. Chart 5Investment Spending And Profits Are Linked While we think that weak foreign growth will weigh on corporate profits in the coming quarters, presenting a clear negative for corporate bond spreads. We must also consider that spread widening during the past two weeks means that valuation has improved. Our measure of the excess spread available in the High-Yield index after accounting for expected default losses now stands at 274 bps, up from 212 bps a month ago and slightly above the historical average (Chart 6). However, we must also point out that our calculation embeds expected default losses of only 1.04% for the next 12 months. This low default loss expectation, which is derived from Moody's baseline default rate forecast and our own forecast of the recovery rate, means that there is a high risk that default losses surprise investors to the upside during the next 12 months (Chart 6, bottom panel). Any moderation in profit growth would make such an upside surprise even more likely. Chart 6Junk Value Has Improved... Another way to think about our default-adjusted high-yield spread is that if we assume that default losses occur in line with our forecast and that junk spreads remain flat at current levels, then junk bonds will outperform duration-matched Treasuries by 274 bps during the next 12 months. If spreads tighten by enough to bring the default-adjusted spread back to its historical average of 247 bps, then junk will outperform duration-matched Treasuries by 380 bps. However, at the current juncture we are more worried about spread widening during the next 6-12 months than spread tightening. Chart 7 shows that junk spreads tend to predict changes in capacity utilization. At current spread levels, this means we should expect capacity utilization to rise back to the 80% level during the next six months. If weak foreign economic growth starts to weigh on U.S. corporate profits, then such a large gain is very much in doubt (Chart 7, bottom panel). Chart 7...But Spreads Embed Strong IP Growth Bottom Line: Weak foreign economic growth will impact U.S. corporate profits and investment spending before hitting U.S. consumer spending and overall GDP. This means it is better to hedge the risk from weak foreign growth by scaling back exposure to corporate bonds, while maintaining below-benchmark duration. Extend Maturity In Credit, Not Treasuries Given the risk to corporate profits that is posed by weak foreign economic growth, we recommend investors maintain only a neutral allocation to corporate bonds and also maintain an up-in-quality bias across credit tiers.2 In the current environment we think the best way to pick-up spread within a neutral allocation to corporate bonds is to favor the long-end of the maturity spectrum. This will need to be offset by maintaining very low duration within your Treasury allocation to ensure that overall portfolio duration stays below benchmark. The rationale for favoring the long-end of the corporate credit curve is twofold. First, there is extra spread available at the long-end of the credit curve compared to the short-end. In fact, the long-maturity investment grade corporate bond index carries an average option-adjusted spread that is 107 bps greater than that of the intermediate-maturity index (Chart 8). Second, the extra spread available at the long-end of the credit curve is purely compensation for the extra duration risk. The bottom panel of Chart 8 shows that there is no spread advantage at the long-end on a "per unit of duration" basis. Chart 8Favor The Long-End Of The Corporate Credit Curve The fact that the extra spread at the long-end of the credit curve is purely compensation for duration is important because it means that when Treasury yields rise and average index duration falls, investors should demand less compensation for the extra duration risk at the long-end of the curve. In other words, rising Treasury yield environments should coincide with spread compression at the long-end of the credit curve versus the short end. We tested this idea empirically by looking at monthly excess returns in long-maturity corporate bonds versus short-maturity corporate bonds. Using a sample of monthly returns going back to 2000, we divide the months based on whether the Treasury curve bear-steepened, bear-flattened, bull-steepened or bull-flattened (Table 1). The results show that while changes in the slope of the yield curve don't have much impact, the long-end of the credit curve outperforms when Treasury yields rise and underperforms when they fall. Table 1Monthly Excess Return In Long Maturity Vs. Short Maturity Corporate Bonds (2000-Present) Bottom Line: Favoring the long-end of the credit curve is a way to increase the average spread of a bond portfolio without taking on extra credit risk. Rather, the long-end of the credit curve outperforms when Treasury yields rise and underperforms when they fall. In the current environment we prefer going after the extra spread at the long-end of the credit curve, while maintaining an up-in-quality bias and only a neutral allocation to corporate bonds. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Waiting For Peak Divergence", dated October 23, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "Rigidly Defined Areas of Doubt And Uncertainty", dated June 19, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Asset allocation: overweight industrial commodities versus equities... ...and neutral equities versus bonds. The euro: neutral for a broad basket but stay long JPY/EUR. The pound: long-term upside, but a better entry point awaits for those who can fine tune. Italian assets: buy when the 10-year BTP yield moves closer to 3 percent. Feature Some people ascribe this year's market action to economics, others ascribe it to geopolitics, but we put it down to mathematics (Chart of the Week). Chart of the WeekEquities Are In 'No Man's Land' As my colleague Peter Berezin recently pointed out, economies and markets can undergo disruptive 'phase transitions' analogous to when water transitions to ice. For water, a 4 degree drop in temperature from 6 degrees to 2 degrees produces no discernible effect, but the same 4 degree drop from 2 degrees to minus 2 degrees produces major disruption, as roads freeze over, pipes burst, and so forth.1 Similarly, as economic or financial stresses build, nothing discernible happens until a phase transition is reached, at which point everything goes haywire. Our thesis is that markets may be near such a phase transition. To explain why, we first need to correct the great misunderstanding of finance, the misunderstanding of risk. The Evolutionary Basis Of Investment Risk One of the major breakthroughs in behavioural finance was the discovery that we care deeply about the asymmetry of an investment's potential returns. Rationally, this asymmetry shouldn't matter if the expected value of the gains equals or exceeds the expected value of the losses. But it does matter, and the reason is that we significantly overestimate the probabilities of extreme tail-events (Chart I-2). Chart I-2We Overestimate The Probability Of Tail-Events Evolutionary biologists argue that this bias originated tens of thousands of years ago, when our distant ancestors had to survive daily 'fight or flight' threats. Faced with constant mortal danger, there was no time for measured analysis. Survival depended on a quick processing of choices into simple chunks: no risk, low risk, high risk. Thereby, our brains evolved to process a one in thousand and, say, a one in hundred chance of danger simply into the 'low risk' chunk, meaning that the 0.1 percent risk is overestimated to 1 percent - or whatever we define as low risk. Fast forward to today's financial markets, and our brains still overestimate extreme tail-events. It follows that for investments whose return distributions are asymmetric, the more extreme tail dominates the perception of its risk. Put simply, investors assess the risk of an investment in terms of its most extreme potential loss versus its most extreme potential gain in a short space of time (Chart I-3). Chart I-3Investors Assess Risk As The Most Extreme Potential Loss Versus Gain Why in a short space of time? The answer is that while most professional investors have long-term objectives, they must report mark-to-market performances every quarter or half-year. Unfortunately, a fund manager who delivers a deep short-term loss is in grave danger of being fired - the modern day equivalent of our distant ancestors' daily fight for survival. And it is nominal losses that matter because even in a period of deflation, any decline in the price level is unlikely to boost real returns over a period of a few months. Correcting The Great Misunderstanding Of Finance So the great misunderstanding of finance is to equate risk with volatility. Risky assets, such as equities, are risky not because they are volatile in the conventional (root mean squared) sense. After all, nobody worries if the price goes up sharply! Also, it is a great misunderstanding to think that equities do not provide diversification benefits. They clearly do - witness the protection that equities provided to bondholders in the bond bloodbath that followed President Trump's surprise victory in 2016 (Chart I-4). Chart I-4Equities Protected Bondholders In The Post Trump Victory Bond Bloodbath The real reason that risky assets are risky is because they have the propensity to experience much larger short-term losses than short-term gains - captured in the saying: equities climb up the stairs on the way up, but they jump out of the window on the way down. But here's the key point. At very low bond yields, bond returns develop the same (or worse) asymmetry as equity returns. Given the lower bound to yields, bond prices have no more stairs to climb... only a window to jump out of! (Chart I-5) The upshot is that equities lose their excess riskiness versus bonds, meaning that their valuations experience a phase transition sharply upwards. The corollary is that when bond yields normalise, equities regain their excess riskiness versus bonds - and their valuations must suffer a phase transition sharply downwards. Chart I-5At A 2% Bond Yield, Bond Returns Have the Same Negative Asymmetry As Equity Returns According to our empirical and theoretical analysis, this phase transition sharply downwards is most pronounced when the global (10-year) bond yield rises through 2 percent. In rule of thumb terms, this is when the sum of the yields on the T-bond, German bund and JGB breaches and remains above 4 percent (Chart I-6). At such a phase transition, it would be prudent to de-risk portfolios and sit aside, at least for a while. Chart I-6When The Sum Of 10-Year Yields On The T-Bond, Bund, And JGB = 4%, The Global 10-Year Yield = 2% Just below this level, a sum in the 3-4 percent range defines a kind of 'no man's land' in which equities drift sideways, perfectly explaining the behaviour of the market through the past year. With the sum now at 3.75 percent, the current message is to remain at neutral allocation to equities versus bonds. Instead, our main asset allocation recommendation is a relative value position: long industrial commodities versus equities - and the position has already gained 4 percent in the past two weeks. The Main Risk For European Institutions Is Existential Sticking with this week's theme of risk, the main risk confronting Europe's major institutions such as the ECB, the EU Council, and the EU Commission is an existential risk. This is because the very existence of the pan-European project relies on the ongoing (largely) unanimous support of a collection of sovereign European nations. As these sponsoring nations often have conflicting claims and interests, Europe's major institutions have intentionally designed themselves as rules-based organisations. Adherence to the rules is essential to avoid the bias, exceptionalism, and moral hazard that could tear apart the pan-European project. And this simple unifying principle explains the current stance of the ECB towards monetary policy, the stance of the EU Council towards Brexit, and the stance of the EU Commission towards the Italian budget. For the ECB, its main policy tools - interest rates, forward guidance on interest rates, and asset purchases - are calibrated to deliver its single objective: aggregate euro area CPI inflation 'below but close to 2 percent'. After a recent wobble in euro area growth, the 6-month credit impulse has ticked up (Chart I-7). Hence, it would be hard for the ECB to conclude that the convergence of inflation to its medium-term target has been blown off course (Chart I-8) - so we expect no major changes to the ECB's forward guidance. Leaving our overall stance to the EUR as neutral, with a preferred long exposure to JPY/EUR. Chart I-7The Euro Area 6-Month Credit Impulse Has Ticked Up Chart I-8Euro Area Inflation Has Been Drifting Up To Target Turning to the EU Council's strategy for Brexit, it will be unyielding on the indivisibility of the EU's four freedoms: goods, services, capital, and people. To do otherwise would be to undermine the strength and integrity of one of the EU's greatest achievements: the largest single market in the world. To give the U.K. special favours would risk giving it an unfair competitive advantage, as well as setting a dangerous precedent for other EU countries that wanted out. Hence, to avoid a hard North/South or East/West border for Ireland, the U.K.'s only option will be to remain indefinitely in a customs union with the EU. Once this is recognised and accepted by the U.K. parliament, the pound will rally.2 Finally, relating to the Italian budget, the EU Commission will adhere to the broad principle of its fiscal rules - again, because it cannot set a dangerous precedent for others. However, there may be some 'give' on the 2019 deficit in return for some 'take' on the 2020 and 2021 deficits. Ultimately, we expect de-escalation and compromise in this battle - but we recommend remaining neutral towards Italian assets until the 10-year BTP yield moves closer to 3 percent (Chart I-9). Chart i-9Remain Neutral Italian Assets Until The 10-Year BTP Yield Moves Closer To 3% Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Please see the Global Investment Strategy Weekly Report 'Phase Transitions In Financial Markets: Lessons For Today' October 19, 2018 available at gis.bcaresearch.com 2 Please see the European Investment Strategy Weekly Report 'Understanding Brexit, Scandinavian Markets, And Semiconductors' October 18, 2018 available at eis.bcaresearch.com Fractal Trading Model* This week we note that the sharp sell-off in the Portuguese stock market is technically exhausted and ripe for a countertrend move. We prefer to express this as a market neutral pair-trade: long Portugal/short Hungary. Set the profit target at 6% with a symmetrical stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - 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
Our Global Fixed Income Strategy team is currently underweight euro area government bonds. They recommend tracking the following indicators to determine if the view remains appropriate. In its latest set of economic projections published last month, the ECB…
Inflation Expectations We have frequently noted that inflation expectations embedded in long-dated Treasury yields remain too low compared to levels consistent with inflation being well-anchored around the Fed’s 2% target. It stands to reason that…
Nominal GDP Historically, a 10-year Treasury yield above the nominal GDP growth has coincided with downward pressure on core inflation, signals that we are approaching the end of the cycle, and therefore a rising likelihood of recession and bear market. With…
The yield curve has steepened somewhat during the past few weeks as yields at the long-end of the curve have moved higher while short-end yields have been roughly unchanged. The spike in yields corresponded with a spike in bond volatility (see chart) Our U.S.…
Highlights Duration: Foreign economic growth continues to diverge negatively from growth in the United States. The resulting upward pressure on the U.S. dollar will eventually drag U.S. growth down, and could temporarily threaten the cyclical uptrend in Treasury yields. But so far there is no evidence that dollar strength is too much for the U.S. economy to handle. Investors should maintain below-benchmark duration until signs of contagion are more apparent. Yield Curve: A reading of the macro drivers of the yield curve suggests that the slope of the curve will not steepen or flatten dramatically during the next 6-12 months. In this environment, trades that are long the belly of the curve and short a duration-matched barbell consisting of the short and long ends will profit, due to extremely attractive valuation. We currently recommend going long the 7-year bullet and short the 1/20 barbell. Feature If investors were already worried about the impact of restrictive Fed policy on credit spreads and equities, the minutes from September's FOMC meeting - released last Wednesday - did nothing to calm their nerves. The minutes revealed that "a few participants expected that policy would need to become modestly restrictive for a time" while an additional "number" of participants "judged that it would be necessary to temporarily raise the federal funds rate above their assessments of its longer-run level." There is a small distinction between the "few" participants who expect that a fed funds rate above the estimated longer-run neutral level of 3% will be necessary because restrictive monetary policy will be warranted and the "number" of participants who think that the fed funds rate will move above 3% without policy turning restrictive. However, the main takeaway for investors should be that a large portion of the committee expects that rate hikes will continue until the fed funds rate is at least above 3%. In last week's report we explored the risk that higher yields lead to an excessive tightening of financial conditions and actually sow the seeds of their own decline.1 But we do not view that as the greatest threat to our recommended below-benchmark portfolio duration stance. The biggest risk to that view comes from the ongoing divergence between strong U.S. and weak foreign economic growth. No Contagion... Yet Chart 1 shows that, since 1993, every time our Global (ex. U.S.) Leading Economic Indicator (LEI) has fallen below zero, the U.S. LEI has eventually followed. But while the Global (ex. U.S.) LEI has now been below zero for nine consecutive months, there is so far no evidence of contagion into the United States. The resilience of the U.S. economy probably explains why the September FOMC minutes only briefly mentioned the risk from weak foreign growth. Chart 1U.S. And Foreign Growth Continue To Diverge From the minutes:2 The divergence between domestic and foreign economic growth prospects and monetary policies was cited as presenting a downside risk because of the potential for further strengthening of the U.S. dollar... But: Participants generally agreed that risks to the outlook appeared roughly balanced. The concern is that, much like in the 2014-16 period, the divergence in growth between the U.S. and the rest of the world puts so much upward pressure on the dollar that it eventually drags U.S. growth and bond yields lower. But despite this year's 4.6% appreciation in the trade-weighted dollar, we have yet to see any impact on our Fed Monitor and Treasury yields remain in an uptrend (Chart 2). This suggests that we have not yet reached peak divergence between U.S. and foreign growth. Further divergence and dollar strength is necessary before the U.S. economy is negatively impacted. Chart 2More $ Strength Required The reason why the dollar's recent appreciation has not yet exerted a discernible impact on the U.S. economy might be because overall global GDP growth is on a more solid footing than it was in 2014-16 (Chart 3). The IMF forecasts that global GDP growth will be 3.7% in 2018 and 2019, compared to 3.5% in 2015. Meanwhile, the moderation in Eurozone growth represents a decline from lofty 2017 GDP growth of 2.4%. Even in emerging markets, where the global growth slowdown is most apparent, the IMF is still forecasting GDP growth of 4.7% for both 2018 and 2019, a far cry from the 4.3% seen in 2015 (Chart 3, bottom panel). Chart 3Global Growth Stronger Than 2014-16 Of course, IMF forecasts can always change, and they likely will be revised lower if current trends continue. However, the key point for bond investors is that the global economy is in much better shape than it was between 2014 and 2016. This means that non-U.S. growth needs to see further significant weakness before the uptrend in U.S. Treasury yields is threatened. Bottom Line: Foreign economic growth continues to diverge negatively from growth in the United States. The resulting upward pressure on the U.S. dollar will eventually drag U.S. growth down, and could temporarily threaten the cyclical uptrend in Treasury yields. But so far there is no evidence that dollar strength is too much for the U.S. economy to handle. Investors should maintain below-benchmark duration until signs of contagion are more apparent. Can Uncertainty Steepen The Yield Curve? The yield curve has steepened somewhat during the past few weeks, the result of much higher yields at the long-end of the curve and short-end yields that have been roughly unchanged. We think Fed communication has been an important catalyst for this curve action. Specifically, the Fed's deliberate attempt to introduce uncertainty around its estimates of the neutral fed funds rate.3 Bond investors are finally getting the message that the Fed's median forecast of a 3% longer-run fed funds rate is not written in stone. Depending on the economic outlook, the funds rate could peak for the cycle at a level that is well above or below 3%. Given the recent spate of strong U.S. economic data, the market is starting to discount a peak that is above 3%, no matter what median forecast appears in the Fed's dots. This raises the question of whether a further un-anchoring of long-dated yields could occur. Is it possible that the yield curve will continue to steepen, even with the Fed lifting short rates at a gradual pace of 25 basis points per quarter? Below, we review a few different macro drivers of the yield curve and conclude that neither a large steepening nor large flattening is likely during the next 6-12 months. Nominal GDP Growth One useful rule-of-thumb for when monetary policy turns restrictive is when the 10-year Treasury yield exceeds the rate of growth in nominal GDP. In the past, a 10-year yield above the rate of growth in nominal GDP has coincided with downward pressure on core inflation (Chart 4). With that in mind, we note that nominal GDP has grown by 5.44% during the past year, by 3.98% (annualized) during the past two years and by 3.85% (annualized) during the past three years. Chart 410-Year Yield & Nominal GDP We discount the recent 5.44% growth rate because it was largely fueled by fiscal thrust that will fade in the coming quarters. This leaves us with a recent trend of 3.85% - 4% in nominal GDP growth. Even with no further deterioration in growth as the cycle matures, this puts an approximate cap on how high long-dated yields can rise before policy becomes restrictive and the cycle starts to turn. With the 10-year Treasury yield already at 3.19%, it can rise by between 66 bps and 81 bps before it reaches that range. If that adjustment were to occur very quickly, then the yield curve would steepen sharply and then re-flatten as the Fed lifted rates to catch up with the long end. Alternatively, if that adjustment were to occur over a period of 6-9 months, with the Fed hiking at a pace of 25 bps per quarter, the slope of the yield curve would be roughly unchanged. Wage Growth While nominal GDP growth is useful for thinking about long-maturity yields, wage growth correlates quite strongly with the slope of the yield curve itself. Specifically, rapid wage gains tend to coincide with curve flattening, and vice-versa. In fact, a typical cyclical pattern is that first the yield curve flattens and then wage growth accelerates to catch up with the curve (Chart 5). It would be highly unusual for the yield curve to steepen significantly while wage growth is rising, which it finally appears to be doing. Chart 5Higher Wage Growth = Flatter Curve We cannot completely rule out the possibility that stronger productivity growth actually causes unit labor costs to decelerate even as "top line" wage pressures mount. Unit labor costs are essentially the ratio of wages (compensation per hour) to productivity (output-per-hour), and the bottom panel of Chart 5 shows that a deceleration in unit labor costs could cause the yield curve to steepen. However, we note that there is not much precedent for strong productivity growth overwhelming an acceleration in wages, causing unit labor costs to diverge from other wage measures. For example, even as productivity growth strengthened in the 1990s, unit labor costs continued to rise alongside other measures of wage growth. Inflation Expectations We have frequently noted that inflation expectations embedded in long-dated Treasury yields remain too low compared to levels that are consistent with inflation being well-anchored around the Fed's 2% target. It stands to reason that long-maturity TIPS breakeven inflation rates could steepen the yield curve as they adjust higher. However, the 10-year TIPS breakeven inflation rate is currently 2.11%, only slightly below the range of 2.3% to 2.5% that has historically been consistent with well-anchored inflation expectations (Chart 6). In other words, the upside in long-dated breakevens is now fairly limited. In contrast, the 2-year TIPS breakeven inflation rate stands at only 1.70%, still considerably below "well-anchored" levels (Chart 6, bottom panel). Chart 6More Upside In Short-Dated Breakevens Further, since the financial crisis, breakevens at both the short- and long-ends of the curve have been driven by trends in the actual inflation data (Chart 7). If it is rising realized inflation that has driven both the 2-year and 10-year TIPS breakeven inflation rates higher this cycle, and the 2-year rate is further away from target than the 10-year rate, then it stands to reason that inflation expectations are more likely to exert flattening pressure on the nominal yield curve than steepening pressure. Chart 7Realized Inflation Is Driving Expectations Rate Volatility & The Term Premium One final macro driver that could steepen the yield curve would be a spike in interest rate volatility and an increase in the term premium at the long-end of the curve. Our prior research has shown that implied interest rate volatility is linked to uncertainty about the macro environment, and Chart 8 shows that the MOVE index of implied interest rate volatility has tended to track the dispersion of individual forecasts of 3-month T-bill rates and GDP growth. In this context, it should not be surprising that implied volatility fell to very low levels when interest rates were pinned at zero and not expected to move for an extended period. Chart 8Macro Uncertainty & Rate Volatility But, as was mentioned above, the Fed has been trying scale back its forward guidance and inject some uncertainty into the market. Indeed, we think this is one reason why the yield curve steepened and rate volatility increased during the past few weeks. Taking a broader view, we also observe that, historically, macro uncertainty and implied interest rate volatility have tended to fall when the Fed is hiking rates, only spiking once monetary policy becomes restrictive and the economic recovery is threatened. The yield curve is typically inverted by that point. This leaves us to conclude that some further increase in interest rate volatility from exceptionally low levels is possible, but a large spike is unlikely until monetary policy becomes restrictive. Investment Implications A survey of the macro drivers of the yield curve leaves us to conclude that the most likely outcome for the next 6-12 months is that the slope of the curve remains close to its current level, meaning that the curve undergoes a roughly parallel upward shift as the Fed continues to lift rates. However, if nominal GDP growth fails to decelerate from its current 5.44% clip, it is possible that the yield curve steepens first and then flattens as the Fed lifts rates more quickly to catch up. This is not the most likely outcome, but rather a risk to our base case scenario. The final piece of the puzzle is the observation that curve steepener trades continue to look attractively priced. Our current recommendation is to favor the 7-year bullet over a duration-matched barbell consisting of the 1-year and 20-year notes. This trade offers a spread of +8 bps above the reading from our fair value model (Chart 9). Or alternatively, our model shows that the 1/7/20 butterfly spread is currently priced for 29 bps of 1/20 curve flattening during the next six months (Chart 9, bottom panel). Chart 9Curve Steepeners Are Still Attractive That much curve flattening is highly unlikely in the current macro environment, and we continue to recommend curve steepener trades to profit from an unchanged yield curve during the next six months. Bottom Line: A reading of the macro drivers of the yield curve suggests that the slope of the curve will not steepen or flatten dramatically during the next 6-12 months. In this environment, trades that are long the belly of the curve and short a duration-matched barbell consisting of the short and long ends will profit, due to extremely attractive valuation. We currently recommend going long the 7-year bullet and short the 1/20 barbell. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1Please see U.S. Bond Strategy Weekly Report, "Rate Shock", dated October 16, 2018, available at usbs.bcaresearch.com 2https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20180926.pdf 3Please see U.S. Bond Strategy Weekly Report, "Rigidly Defined Areas Of Doubt And Uncertainty", dated June 19, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification