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StreetStuff Daily March 28, 2017

27 March 2017

Tight Oil Production Outlook

Record high in sight Rising oil prices resulting from the OPEC deal have breathed new life into the US E&P sector, which is likely to complicate OPEC’s decision in May. If production growth exceeds expectations, it could threaten to undo the work of OPEC members last fall. We update our forecasts and increase our expectation for US crude production by major producing basin. Since January, our exit-to-exit (4Q/4Q) growth forecast for L-48 onshore has been revised higher by 340 kb/d, to 770 kb/d, due to baseline downward revisions and higher drilling and completion expectations. We now forecast US crude oil production to reach a multi-decade high by December, within sights of the all-time high reached in 1970 FIGURE 1 US crude oil production is expected reach multidecade highs by 2017-end

BECAUSE: The way to get good ideas is to go through LOTS of ideas, and throw out the bad ones… we’re left simply scratching our heads with little to contribute beyond a healthy distrust of any claim of what it ‘really means’. The uncertainty surrounding the political landscape will undoubtedly be with us for a while to come and frankly it has been the most meaningful contributor to the bullish price action that we’ve seen in the recent weeks. With 10-year yields still shy of the opening gap we’ve been targeting in a rally – 2.303% to 2.317% -- we’re reluctant to be aggressive sellers of the market. If anything, we’d book profits and step away while the market takes down supply and the upcoming round of economic data. We have a similar opening-gap in the long-bond that comes in at 2.945% to 2.948% and now that 30-year yields have broken through 3.00% the gap is more meaningful. In terms of support for the market if we should see a more sustainable reversal, we’re tracking another series of opening gaps that were formed on Monday. In 10s, we see 2.382% to 2.412%, followed by the 40- and 21-day moving-averages at 2.456% and 2.485%, respectively. In the longbond, the gap is 2.992% to 3.013% with the 40- and 21- day MAs at 3.062% and 3.086%, respectively. As it relates to Tuesday’s auction, the 5-year gap is significant at 1.917% to 1.948% -- a large nilvolume zone to fill ahead of the 40-day movingaverage at 1.957%. That would represent a solid back-up in yields given the early price action, but if a more tangible pre-auction concession emerges, we’ll be watching those levels

Lyngen/Kohli BMO Closing Call, March 27 (attached) 27 Mar 2017

…Tactical Bias Treasuries repriced at the beginning of this week as the market continues to gauge the full impact of the abandoned healthcare reform bill. We’d like to offer something insightful (or at least witty) to the discourse on the fallout from what many have characterized at Trump’s political misstep, but alas

Economic Desknote US - Tax cut implications of pulling the AHCA •

Withdrawing the AHCA, the Obamacare repeal and replace bill, has damaged the President’s authority

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and momentum and has similarly scarred the Republican leadership. A tax reform will create losers who will be emboldened that the President can be faced down when confronted by strong opposition. The need for success on the tax reform front has risen, but there is less cash to play with now. The temptation to go with simpler reforms (e.g. ditching the Border Adjustment Tax) has risen, as has the temptation to go for sunset provisions and to modify filibuster rules.

Global Daily Macro Monitor

28 March 2017 •

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US : Four Fed officials, including Chair Yellen, are scheduled to speak on Tuesday; we do not expect much new information. Consumer confidence is likely to decline but remain elevated. Eurozone: Survey data continue to beat expectations, flagging upside risks to our growth forecasts. The case for less monetary accommodation seems well supported.

US Rates at the Bell March 27th, 2017

… Recap & Discussion: “When one door closes, another will open, but standing in that hallway can be hell.”. It’s within this painful narrative limbo that many economically-sensitive assets lie in the post-ACA vote trading environment. At first glance, it would seem the pernicious P’s of positioning and politics are in the short-term driver seat. The former is no doubt the freshest wound, with the invalidated spending cuts from the ACA repeal being viewed as both a calendar and efficacy obstacle to the administration’s fiscal stimulus sequence. Intertwined is the latter, with CFTC and open interest data showing that cross-asset positioning (see charts 1-3), which has been pricing in expectations of meaningful regulatory/tax reform, is now being reversed as progrowth catalysts are being pushed farther beyond the discounting horizon of long duration assets. At a second glance however, it’s not as simple as TOTO (Trump-on,

Trump-off), because #AmericaFirst is no longer reflected in asset markets as econ data trends, yield differentials, and now even equity performance has put Europe at the fore, something which we continue to see as a near-term source of volatility and trend disruption, but also as a future bearish driver of duration markets beyond the political echo-chamber (given the implication for tighter monetary policy abroad). As we illustrate in charts 4-6, whether a product of the FXchannel (or real rate differentials), EU data is now accelerating even faster than the US on a nominal and relative basis, which is now being reflected in tightening spreads and EURUSD. In addition to the very recent slowing of US-based “soft” survey data (charts 7-9) as well as legislative disappointment, we think it’s logical that investors have begun to unwind bearish positions given the uptick in realized and implied vol (VIX now making higher highs/lows), but we do not think that the newfound policy convergence theme will be the prototypical risk-off event. While typically US-EU yield spread convergence is a harbinger of major riskasset dislocations, we think that this episode is a precondition for normalizing monetary policy globally…a spur which (after some growing pains for risk-free rate discounted asset classes?) should allow for higher US and EU yields in unison. In the near-term however, there are numerous technical factors which have to be mitigated before rates can make a meaningful base in our opinion:  In 5s and 10s we are intent on seeing a significant defense of the 1.85-1.90 and 2.31-2.33 buffer zones on a weekly basis, respectively.  Real-Yield wise, -0.20bps (200dma) for 5yr reals and 0.285 (horizontal resistance) for 10yr reals are major trend delineators.  On an intermarket basis, USDJPY and DXY selloffs need to find support and/or correlations to 10yr USTs need to diminish further (0.25 & 0.14 currently on 60-day rolling basis). 27 Mar 2017 09:35:49 ET

RPM Daily

Short Covering Leading Yields Lower in UST In US, covering drove the rally in USTs as the market continues to liquidate short positions, as investors question the rest of

Trumps pro-growth agenda. Around $3.5mln DV01 of shorts where reduced (particularly in the belly of the curve in both cash and futures), leaving in place only a small short bias of -0.4 (out of -5.0). Meanwhile RPM remains long 5y and maintains dovish curve plays in cash.

Chart 2

Vladimir Ragulin 27 Mar 2017 11:08

CFTC/Dealer Positions -- Real Money Re-Building Longs, Balance Sheets Tight into Q/E

Source: Citi, CFTC

See below charts and tables summarizing the latest CFTC Commitment of Traders (COT), Traders in Financial Futures (TFF) reports based on positions for COB 03/21 (i.e. last Tuesday), the most recent NY Fed Primary Dealer (PD) Positions report as of 3/15 as well as the Liquidity Premium Index produced by the Citi Treasuries Desk.

27 Mar 2017 07:22:44 ET

During the week prior to the latest CFTC 10yr duration sharply rallied (10y yield 2.60% -> 2.42%) on concerns over President Trump’s ability to deliver his signature AHCA legislation putting in question Congressional support for the rest of his ambitious stimulus program.

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US Treasuries: • In the long-end Asset Managers started rebuilding longs, offset by larger shorts among the dealers. Unlike earlier this year, Leveraged accounts have been gradually reducing shorts. The old COT classification also shows a small decline in Non-Commercial shorts. (Chart 1). • In the short-end, we saw an across-the-board risk reduction by all investor categories. (Chart 2) Chart 1

Global Municipals Strategy Focus Pivot to tax reform?

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When Mr. Trump was elected President the bond markets got a little ahead of themselves and seemed a bit too willing to price in fiscal stimulus, passage of a large infrastructure spending bill, deregulation in the financial markets etc. while ignoring the obvious challenges facing these initiatives. After the initial bout of optimism, the markets seem to be trading more on headlines around the risks to this reflation trade. We must admit that we are guilty of taking statements by key lawmakers at face value and expected the Republican administration to pivot to tax reform only after summer. And, while the bill to repeal ACA was expected to face an uphill battle, the tailspin that resulted in Republicans dropping the effort and walking away was unexpected, to say the least. So now, will the focus indeed shift to tax-reform? And if so, what are the chances of its passage? We discuss.

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are the markets likely to price in renewed risks to the reflation trade?

Source: Citi, CFTC

So far municipals have largely mirrored Treasuries as the markets have priced in the reflation trade. But, longer dated municipals have been extremely sensitive to headlines regarding tax-reform. While a lower top marginal tax rate has posed some

bearish risk for high grade municipals, it is the probability of a lower corporate tax rate that has influenced long end ratios more (owing to the possibility of a demand gap from banks and insurance companies). We expect the broader fixed income market to witness a moderate rally after the recent turn of events. But, we believe that the recent events have also served to desensitize the markets somewhat and after the initial rally most investors are likely to adopt a wait-and-watch attitude rather than overreact to every headwind (or tailwind) to the reflation trade. Thus, we expect municipal Treasury ratios to remain largely range bound in the medium term. 27 Mar 2017 20:41:35 ET

Global Economics View Advanced Economy Monetary Conditions Remain Accommodative •

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Long-term nominal interest rates have risen somewhat since mid-2016 across many advanced economies (AEs) and markets have in recent months begun to price in expectations of higher short rates. In this note, we consider a broader measure of monetary conditions that reflects real (rather than nominal) policy rates, real long-term (10Y) government bond yields and real effective exchange rates (REERs) in the US, euro area, Japan and the UK (which we refer to as G4). On this broader measure of G4 monetary conditions, there is no clear sign of tightening in 2017 or over the last year. In fact, monetary conditions may have eased somewhat due to rising inflation, higher inflation expectations and (ex-US) weaker exchange rates. Compared to historical (18-year) averages, monetary conditions remain very loose in the euro area (-2.5pp) and the UK (-5.4pp), while still moderately loose in Japan (+0.6pp) and the US (-0.4pp) (mostly due to a strong dollar). Comparing the 1-day index to the 30-day average, conditions appear to currently be loosening in the US, remain steady in the UK while still tightening in Japan and the euro area. Current Citi forecasts (but assuming REER is constant) imply that average G4 conditions will remain roughly unchanged until year-end. Tightening in the UK and EA of 50-60bp is offset by loosening in the US (-30bp) and Japan (-50bp).

Figure 1. Selected Countries – Monetary Conditions Index (%), Jan-15 – Mar-17

21 Mar 2017 14:02:55 ET

Energy Weekly Rising Russian, Iraqi and Iranian Exports Pile Pressure on OPEC But Crude Balances Are About To Turn Bullish

Deutsche Bank 27 March 2017

Early Morning Reid Macro Strategy …After a bad start to the US session it felt like the market had its own sugar hit as the day wore on yesterday. Indeed whether you're shocked at the fact that the S&P 500 only fell -0.10% yesterday (after being as low as -0.94% intra-day) perhaps depends on how much you think Trump's most radical policies were priced into markets. There is an argument for saying that such trades weren't actually priced in much anyway. The examples discussed yesterday within DB were that the 1) Fed funds market pricing are well below the FOMC dots; 2) the Dollar index is now back to where it was at the end of October; 3) the S&P 500 has been performing similarly to how it normally does after a close election (see the PDF for the graph) even if there was a small pop up in February; and 4) that global PMIs are all consistent with where equities should be given the recent strength - a point we've made in previous EMRs. What we don't know though is if some of the strong survey data contains some element of animal spirits only there because of Trump optimism. The fact that global numbers have been strong perhaps indicates that a lot

of the optimism is in fact a global story and not a Trump one. So unless the global story turns then the healthcare debacle shouldn't be too big a hit. Having said that, failure in the tax reform agenda will surely have more impact on animal spirits given its economic importance. So all to play for even if on some measures little obvious indication of success is priced in.

27 March 2017

US Daily Economic Notes Fed still on track for two more rate hikes this year …Fed Chair Yellen's speech today will not likely touch

27 March 2017

Weekly Fund Flows - EM funds benefit from US risk-off flows Rising concerns about the US administration's ability to push through its policy agenda found expression in ninemonth high redemptions for US equity funds. This led developed market equity fund flows into negative territory for the first time since December, and left the bundled 'money at work' without its biggest contributor this year (see Figure 4 on next page). Importantly however, this did not prompt a risk-off cross-read, as a dovish Fed and a weaker dollar meant eight-month high inflows into EM equity and bond funds respectively. Investors' reassessment of the Trump trade were also felt for dedicated sector, as inflation-linked sector fund flows fell to their lowest level since October, with the majority of outflows coming from global financial mandates, which have been one of the main beneficiaries of Trumpflation (see bottom left chart). While the bond-to-equity rotation in the US had cooled off in December and January, it was reignited in February with strong US survey data (see bottom right chart). It remains to be seen how hopes on Trump's policy platform have effected US sentiment data so far, but if the US 10-year bond yields were to rise sharply on the back of tax reform and/or fiscal stimulus (as our fixed income strategists expect), last week's kink in the US bond-to-equity rotation (and as such the DM rotation) should not be an inflection point.

on monetary policy given that she is addressing workforce development challenges in low-income communities. Hence, Kansas City Fed President George (non-voter), Dallas' Kaplan (voter) and Fed Governor Powell will likely be the most relevant speakers today. In addition, Boston's Rosengren (non-voter) and San Francisco's Williams (non-voter) will be speaking on the economic outlook on Wednesday, followed by New York President Dudley on Thursday. Since Dudley is the defacto manager of the Fed's SOMA portfolio, any potential comments on the Fed's balance sheet strategy will be closely scrutinized. Note that Dudley is speaking on financial conditions and the conduct of monetary policy. In general, we expect policymakers to look through any short-term equity market weakness and reiterate their expectation for further rate increases. As the Trump administration pivots toward other tax priorities, the long-term fiscal picture raises questions as to how much capacity there may be for tax reform going forward. As we discuss in the latest US Economics Weekly, when we analyze the period from right before the "Great Recession" up until the present, weak nominal GDP growth—a function of depressed productivity—has had the most deleterious impact on federal government finances. Although the impending fiscal stimulus will most likely cause an increase in the federal debt-to-GDP ratio, its expected impact on the productive capacity of the economy, i.e., potential growth, will limit the magnitude of this increase. An article published less than a month prior to the election by the Urban-Brookings Tax Policy Center (TPC), a nonpartisan organization, estimated that the Trump plan would increase the deficit by less than 2% of GDP this year, and then by 2.5%-3.5% of GDP over the next nine years. As a result, federal debt would rise by

$7 trillion over the next decade. Per the paper's estimates, the debt-to-GDP ratio would increase substantially, to about 110%. However, our projections imply that the debt-to-GDP ratio might not cross 100% in the coming decade.

27 March 2017

Special Report - The risk of deglobalization 2: US border tax adjustment and RMB Based on industry level information, we estimate what a "balanced" RMB depreciation would be if the US starts to implement a border tax adjustment (BTA) along with its tax reforms. While the discussion is largely based on the proposal outlined by the US House Speaker Paul Ryan in A Better Way , the same method can be applied to assessing other tax and trade reforms as well. We find that if the US cuts its current CIT to 20% and then replaces it with a destination-based cash flow tax (DBCFT), the RMB would need to depreciate 5.8-13.7% vs. the dollar to offset the impact on China's trade balance with the US. If currencies of other countries also move to keep their respective trade balances with the US unchanged, the implied depreciation of RMB vs. the CFETS basket (excl. USD) would be around 2.2-2.4%. What is a "balanced" USD-RMB move following the US tax reforms? The US tax reforms would boost the US producers' competitiveness on both the US and the Chinese markets, should the dollar exchange rate remain stable. A balanced RMB depreciation, on the one hand, would partially compensate the Chinese exporters' competitiveness loss on the US market; while on the other hand, would hurt the US exporters' competitiveness to certain degree on the Chinese market. As a result, it minimizes the overall impact on the US-China bilateral trade balance. How big is the balanced RMB depreciation following the US tax reforms? Our estimate of the balanced RMB depreciation is based on industry level information from the US Input-Output Table. It critically depends on the competitiveness impact from the US CIT cut, which would be strong if we

assume all the US industries are currently paying the 35% full CIT, but much weaker if we base our estimate on the de facto tax rates from the I/O table. Assume the US replaces its current CIT with a 20% DBCFT. We find that on average, the Chinese exporters to the US would need a 6.5-14.3% RMB depreciation to offset the negative impact on their competitiveness, depending on the actual effects of the US CIT cut (Figure C1). On the other hand, on the Chinese market, the US exporters would be able to sustain a RMB depreciation of 1.4-9.4% without suffering a competitiveness loss compared with local Chinese producers. Taking both into consideration, our estimate suggests that the balanced RMB depreciation following the US tax reforms would be somewhere between 5.8% and 13.7%. We also estimate the balanced depreciations for the CFETS basket currencies, assuming they move to keep their respective trade balances with the US unchanged as well (Figure C2). The implied RMB depreciation vs. the CFETS basket is 3.0-4.9%, or 2.2-2.4% if the USD is excluded from the basket. What if the USD-RMB rate remained stable after the US tax reforms? Alternatively, if the USD-RMB rate remained stable after the US tax reforms, we find the US trade deficits against China could shrink by as much as US$63-82 billion, or about 17.2-22.5% of its trade deficits vs. China in 2015, assuming a half pass-through and a strong competitiveness impact from the US CIT cut (Figure C3). The majority of this change would come from the decline in US imports from China, likely between USD58 bil and USD77 bil, while a small part of it, some USD5 bil, would be due to the increase of US exports to China.

Monday, March 27, 2017

Monday Morning Outlook The Fed is A Proxy for Government Well, that was fun! The GOP's attempt to reform healthcare hit a brick wall of politics. Conservative Republicans wanted to completely "repeal" Obamacare, while moderates and leaders were willing to keep much of it as long as it cost less. Moving one way or the other lost too many votes. Democrats refused to participate. So, the bill died. …If the Trump Administration reduces regulation, the money supply will increase even if the Fed pays more to banks for holding reserves. The reason – loans are more profitable than Fed interest rates as long as the yield curve is upward sloping. And as long as excess reserves

exist, banks can increase loans and the money supply, which means inflation is a threat and the yield curve will likely remain upward sloping. In other words, an upwardly sloping yield curve makes it virtually impossible to get a tight monetary policy as long as the Fed allows excess reserves. In addition, with the Fed's balance sheet so large, even an inversion does not necessarily signal as much monetary tightness as in the past. At the same time, the US federal government will find it virtually impossible to ever balance the budget again without getting control of spending. The government has managed to make itself so big that its decisions in the next few years will have implications for decades. Leaving excess reserves in the system is economically dangerous, just like not reforming entitlements.

27 March 2017 | 11:50PM EDT

US Daily: Tax Cut or Tax Reform? The Practical Effects of the Failed Health Vote (Phillips) 

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The abandoned health vote was a clear political setback for the Trump Administration and congressional Republicans. However, we do not think it presents as much of a fiscal setback as some have argued, because the health bill and tax bill would have dealt with different aspects of the tax code and because it never seemed very likely that health legislation would produce much net savings. Over the next several weeks, we will be watching three issues for clues on the direction of tax reform: (1) clarity on the border adjusted tax (BAT), which would raise significant revenue but which is likely to be too controversial to pass, in our view; (2) revenue-neutrality, which Republican leaders have insisted on but would make tax legislation more difficult to pass; and (3) the FY18 budget resolution, which is likely to be hard to pass but without which a tax cut would require 60 votes in the Senate.

27 March 2017 | 3:35PM BST

GOAL Kickstart: Where in the world (are equity returns to be found)? This week's focus: We prefer non-US equities In a world of high valuations, elevated uncertainty about long-term growth and continued questions about politics and policy, investors are asking if there will be any more "happy returns" like those during the last eight-year equity bull market. We think non-US equities should outperform on a 12-month basis. Policy optimism and valuations are high in the US, and non-US equity markets have a better cyclical backdrop, are pricing more political risks (in case of Europe) and have less positioning. We also continue to expect global equities to outperform global bonds, but with lower absolute returns than in previous years. In the event of a drawdown, we would expect crossequity market correlations to be high, but in more flat markets (as we forecast for the S&P 500) we think the correlation decoupling we have already seen could continue (Exhibit 1). This is particularly true for MSCI EM, which is cheaper than other equity markets and appears to be entering another growth phase. Key risks to this view are rate risk and commodity prices. Our EM team has highlighted that the impact of higher rates depends on the source of the shock, its tenor and speed, and EM fundamentals; we expect a gradual increase in long-dated rates and see EM fundamentals as improved. Our commodity team also remains confident in higher commodity returns against a backdrop of good global growth. We think MSCI EM calls appear inexpensive, with at-the-money implied vol at its 9th percentile (Exhibit 28). Data based on market closes from Friday, March 17, 2017 to Friday, March 24, 2017 unless stated otherwise.

Exhibit 1: Recently EM's correlation with other equity markets has decoupled, especially the US Rolling 3-month correlation of weekly returns of different equity markets with the S&P 500 (overlapping windows)

27 March 2017 | 2:05PM EDT

USA: GS Economic Indicators Update …Following generally softer housing data last week, we revised down our Q1 GDP tracking estimate by two tenths to 1.8% (qoq ar):

27 March 2017 | 6:37AM EDT

Global Markets Daily: A New Oil Order sell-off (Courvalin)      

The oil market rebalancing seems to be unraveling, with Brent prices at pre-OPEC deal levels… … but despite record high US crude stocks, inventories have continued their 4Q16 decline elsewhere Long-term prices have instead been the largest drivers of the current sell-off… … as the New Oil Order becomes more tangible, with growing visibility on the low cost sources of future supply The rebalancing will continue, in our view, on strong demand and the 1H17 OPEC cuts… … with our 2H17 Brent price forecast of $57/bbl reflecting an expected shift of the forward curve into backwardation

28 March 2017 | 4:47PM JST

Japan Economics Analyst: BOJ’s JGB purchase: Illustrating a possible market reaction to an “official” tapering announcement In this report, we examine the impact of the BOJ’s JGB purchase on 10-year yields and illustrate a possible market reaction to an "official" tapering announcement.

1. There are flow and stock views with respect to the effectiveness of a central bank's bond purchases on yields. Academics and central bankers tend to emphasize the stock effect, while market participants tend to focus on the flow effect. 2. When quantitative easing is stepped up, there is little difference in implications for the direction of the yields whether we take the flow or stock view. When JGB purchases turn downward in flow terms, however, flow and stock move in opposite directions, creating the issue of which view to adopt. The distinction between flow and stock views in terms of the BOJ’s JGB purchases therefore have become important from early 2016, when the BOJ started to reduce the purchase amount gradually. 3. We examined the flow and stock effects of the BOJ’s JGB purchases by estimating a simple 10-year JGB yield model. We found that the stock effect pushes down yields significantly, while the flow effect is not significant. The cumulative stock effect of BOJ purchases on 10-year yields is estimated as roughly 85bp to date under unprecedented easing. 4. We then illustrated possible market reaction to a future official announcement of tapering by the BOJ. If market participants are sufficiently forward-looking, and come to hold the view that the BOJ’s JGB holdings (stock) at a future point are to be reduced meaningfully from the currently assumed level, based on the BOJ’s new flow announcement, there could be an immediate increase in yields. 5. We examined two possible tapering scenarios. Both assume that the BOJ’s annual purchase target will be reduced to ¥50 tn from ¥80 tn. We assume that, in scenario (1), the BOJ announces it will gradually lower its target to ¥50 tn over a two-year period. In scenario (2), the BOJ announces it will immediately lower its target to ¥50 tn and keep the pace in two years. Based on our 10-year yield model, we calculated the upward pressure on 10-year yields would be roughly 9 bp under scenario (1) and about 18 bp under scenario (2).

March 27, 2017 Treasury Market Commentary

Daily Commentary, 3/27 …On the key question of whether the plan will include a border adjustment framework, Chairman Brady said, "I believe it's a given, but it's not because of revenue. That's a big part of it, but the main reason for having that there is our competitors. We want to make sure there's a level playing field between foreign products and made in America products here as well as abroad. We want to simplify the tax code, which is what border adjustment does. It also eliminates any tax incentive to move manufacturing jobs or headquarters

overseas. And so taking that out would have severe consequences. … We are working on significant modifications to make sure that we phase this in, design it right, create the most growth we can." Asked whether if border adjustment couldn't be agreed on he would look to a shift to implementing a smaller cut in the top corporate tax rate to 28% from 35% instead of to 20% to make up for lost tax revenue, he said, "No, we will not. That will not make us competitive. That won't even get us to middle of the pack" internationally. …Receiving in swaps to reduce duration shorts and to hedge mortgage positions led to a significant tightening in spreads along the curve after the move higher last week in front end spreads that came even as LIBOR continued to show less post-FOMC upside than many investors had expected, sending spot and forward LIBOR/fed funds spreads to post-Brexit lows. The benchmark 2-year spread fell 1.6 bp to 34.5 bp , reversing the majority of a 2.5 bp rise last week. The 30-year spread also fell 1.5 bp to -38.75 bp after not moving much last week, and the 10-year spread fell 1 bp to -2.75 bp, reversing a similar widening last week.

March 28, 2017

FX Morning FX Daily Commentary, 3/28 Risky asset markets have rebounded from yesterday’s opening low, supporting our view of the current market setback as a risk pause and not a turning point towards generally lower risk valuations. The US bond market works as a stabiliser with the recent 25bp decline of its 10-year nominal yield helping to push real yields lower too. As along as real yields stay within recent ranges, it may need a substantial re-rating of the USD economy to push risk asset prices lower for longer. Sure, the Trump administration's failure to push through the Obamacare repeal act suggests that the planned tax reform may also be difficult to implement. Moreover, some of the savings hoped to come out of replacing Obamacare are no longer available for tax cuts or infrastructure expansion plans, suggesting the upcoming tax reform may either turn out to be a smaller package or may come along with a higher fiscal deficit. A better US economy. Admittedly, this would be problematic for an economy still running an output gap. The good news is that the US was already closing its output gap late summer last year, suggesting private sector investment spending should accelerate from here. Prospects of an aggressive tax reform would have brought anticipated investment forward, while a less aggressive tax stance suggests the turn towards higher private sector investment running along a more gradual path. Anyhow, prospects for US capital spending remain positive due to the advanced state of its economic cycle.

Over time, more capital spending will increase capital demand and push cyclical productivity growth higher. Both factors together should push US nominal and real yields higher. Yellen, Kaplan, Powell (voters) and George (non-voter) will be on today's Fed speakers list.

March 27, 2017 US Economics

Hard vs Soft Data: Our Take There’s been a good deal of attention paid to the post-election divergence between the so-called soft (sentiment) data in the US, and the hard (quantifiable) data. Graham Secker, our chief European equity strategist and Matt Hornbach, our global head of rates strategy, have captured this divergence in a great chart in their recent notes here and here (Exhibit 1). There is a Record Gap Between the Strength of 'Hard' and 'Soft' US Macro Data

… There are transitory factors we see weighing on growth in 1Q GDP (in particular a very large inventory drawdown and softness in consumer spending primarily on the absorption of higher gasoline prices) and we do expect an acceleration in headline GDP in 2Q to above 3%.This is preliminary tracking. We will hone this estimate following the first official release of 1Q GDP data on March 30. So, if we are right, the US economy will average around 2% growth in 1H17—roughly in line with our expectation for full year 2017 growth, and the Fed’s.

Recall that Chair Yellen was asked at the March FOMC press conference about low indications for 1Q GDP growth, and responded that, "GDP is a pretty noisy indicator. If one averages through several quarters, I would describe our economy as one that has been growing around two percent per year. And as you can see from our projections, that's something we expect to continue over the next couple of years." Importantly, the 3 hikes envisioned by the Fed this year (one of which has been delivered) are predicated on its outlook coming true. So far, so good. Reconcilable Differences Will the hard and soft data reconcile, and in what direction? Optically, a 2Q GDP bounce back would perhaps be taken by markets as the hard data correcting to the soft data—in other words, risk appetite may find renewed inspiration as positive hard data unfolds. But from an economist’s point of view, smoothing through the volatility simply looks like the outlook for around 2% growth remains intact. Moreover, we do expect that the breadth of the 2Q rebound in hard data will be fairly limited, with a swing in consumption as the main driver of the expected 2Q upside, followed by a slightly better net trade and inventory profile. As a consequence, we would not necessarily expect 'hard data' surprise indices to start racing higher if the factors behind the 2Q growth rebound remain narrowly confined to a few sectors as we expect.

March 27, 2017 Muni Monday Morning

NatWest Markets Closing Notes

March 27th, 2017 Recap and Comments: The Treasury market largely held steady during US hours after rallying and bull flattening at the open as investors pondered the path forward for the Trump administration after the AHCA healthcare reform bill was formally tabled on Friday. The Treasury market retained much of its earlier rally, and the USD retained much of its earlier losses, even as the S&P 500 staged a rally during the morning after opening the session well in the red. EUR/USD finished the session off its local highs after briefly trading above 1.09, aided by language from ECB’s Lautenschlaeger that appeared to suggest that investors should be prepared for a change in ECB policy (our read of the quote, as reproduced in the bullets above, was a bit more benign than the initial headline suggested). A quick look at CFTC positioning revealed speculators, as of last Tuesday, hold their smallest EUR short position in nearly three years (chart)..

CFTC Spec. EUR Positioning – Least Short Since 2014

‘90s vs. ‘00s: Better for Music, Better for the Front End of the Curve (Note to readers: there are 15 ‘90s & 2000s song references in this note. Collect them all!) Hiking cycles in the 90s tended to be better for frontend munis than those of the 2000s. Today’s cycle has elements of both. Further, short duration strategies do not consistently outperform the broad muni market. This supports an equal weight duration stance rather than shortening duration ahead of rate hikes. The prospect of 6 rate hikes between now and year-end 2018 brings a key duration debate to the fore: where should investors position on the curve in a rising rate environment? We find that investors often fall into two camps: one prefers the long-end, given the tendency of the curve to flatten during tightening cycles. Others stay short, given higher long-end price volatility – even if nominal rate moves are less severe than down the curve. To address this debate, we looked at index total and excess returns for front-end sectors (1-10Y) over the past four rate hiking cycles, including the current one.

MARCH 28, 2017

FIXED INCOME DAILY SPRING CLEANING Market Update Treasuries

have remained on a stronger footing since FOMC on the 15 March. Growing questions

about Trump’s capacity to implement his plan have supported further gains of late, as the Trump trades (bearish UST, bullish SPX and USD) have partially reversed. The unwinding is best seen in the sharp pullback in net speculative shorts in Treasuries (Graph 1). As such, 10yT has returned to towards the lower end of the range; as long as 2.30% holds, it is business as usual; an unexpected break, however, would lead us to tactically reconsider the bearish bias.

Graph 1: Speculative UST shorts being cut back sharply

We are slightly negative on the upcoming 5y note

auction. The sector does not appear to have a clear set up ahead of the auction as the current 5y note trades rich versus the old 5s on asset swap; however, it is slightly cheap on the curve fly. The 5y note has tailed in seven of the past ten auctions, which is another negative along with the outright yield of the current 7y trading below the stop-out rates of the past three 5y auctions. The auction might see an unscheduled reopening of an old 7y note (T 1.75% 3/22) if the high yield is in the range of 1.75% through and including 1.874% (see Treasury press release).  We hold a negative bias on the upcoming 7y note

auction. The current 7s note trades rich on both of the relative-value metrics (asset swap and the curve). The outright yield level being below the previous four 7y auction stop-out rates is a negative. Comparatively, the 7y note auction has fared better than the 5y note auctions, with only three tails in the past ten auctions, which is slightly positive for the upcoming one along with the likely quarter-end purchases.  The upcoming auctions especially the 7y note

auction might also benefit on the margin from the yearend purchases from Japan as it has purchased Treasury notes/bonds every March since 2008 except in 2012 with average net purchases of $11.5bn. MARCH 27, 2017

FI SPECIAL TREASURY AUCTION PREVIEW Key points The Treasury is scheduled to auction $26bn in 2y notes on 27 March, $34bn in 5y notes on 28 March, and $28bn in 7y notes on 29 March.  We hold a slightly negative bias on the upcoming 2y

note auction as the 2y note does not appear to have a clear set up for the auction from a relative-value perspective. Together with the lack of any concession going in on the back of the rally in Treasuries following the disappointment on the US policy front, this does not bode well for the auction. The sector has tailed in half of the last six auctions. However, the current 2y benchmark outright yield level is currently trading above the stop-out rate of last month’s auction, which on the margin is a positive for the auction. The auction may see an unscheduled reopening of an old 5y note (T 1.625% 3/19) if the high yield is in the range of 1.625% through and including 1.749% (see Treasury press release). Alternatively, the auction might see an unscheduled reopening of an old 7y note (T 1.5% 3/19) if the high yield is in the range of 1.5% through and including 1.624% (see Treasury press release).

5y note auction Recent performance The $34bn 5y note auction in February did not go well. It was awarded at 1.937%, tailing by 0.6bp compared to the 1pm WI yield. This is the fifth 5y auction to tail in the last six. The 2.29x bid/cover ratio was the lowest for the sector since July’s 2.27x. Dealer/brokers’ 37% share of the offered amount was their highest since November. Positioning The latest positioning data show that dealers have cut their holdings in Treasuries due in the 3-6y sector compared with the last auction date. They had a $20.9bn net long position for the week ending 15 March compared with $24.7bn on 22 February (see Graph 4). Relative value The current 5y note is trading rich on asset swap versus old 5s compared with the past two auctions (see Graph 5), and is slightly cheap on the curve relative to the 2s and 10s (see Graph 6).

Overall We are slightly negative on the upcoming 5y note auction. The sector does not appear to have a clear set up ahead of the auction as the current 5y note trades rich versus the old 5s on asset swap; however, it is slightly cheap on the curve fly. The 5y note has tailed in seven of the past ten auctions, which is another negative along with the outright yield of the current 7y trading below the stop-out rates of the past three 5y auctions. The auction might see an unscheduled reopening of an old 7y note (T 1.75% 3/22) if the high yield is in the range of 1.75% through and including 1.874% (see Treasury press release).

MARCH 28, 2017

FX DAILY DON'T WORRY, BE HAPPY Bloomberg's ‘most read' news story overnight was entitled “equities rebound as worries ease, dollar steadies”. That sets the tone for today and the title of our economics team's Morning call - [Low-key Yellen speech the focus on a quiet day : https://doc.sgmarkets.com/en/1/0/136122/197560.html?s id=281ef4b3a31c4951ca21c15d079c7ea3]gives me an idea of what to expect. Bond and FX market participants' reaction to the failure of the healthcare bill has been to re-price Treasuries and the Dollar under the assumption that President Trump has lost a little of his shine. Equity market participants have taken a look at the lower yields and weaker dollar and decided that since absurdly low rates are the elixir that the equity bull market lives on, they might as ‘buy the dip' yet again. And that kind of attitude is going to have the FX market off in search of high-yielding currencies in the blink of an eye. If there's one indicator to watch at the moment, it's the trend in breakeven inflation rates. US 10year breakevens are drifting gently lower, below 2% now. Comments from investors, and from central, bankers, reflect the sense of uncertainty now about whether core inflation is going to get back to or above target for a sustained period of time. Japanese 10year breakevens are at 0.5% now, down from a peak above 0.6% in December. Germany's are at 1.2%, down from a 1.35% peak in January. The exception is the UK, where the underlying trend is flat to slowly higher. As long as that's reflected in expectations of tighter MPC policy it won't hurt the pound, but it's a false friend. Persistent inflation without rate increases is bad for the currency, and a downward rethink to the rate outlook as inflation expectations fall wouldn't help either. There's no UK news and tomorrow's triggering of Article 50 won't come as a surprise, but staying long EUR/GBP works for me.

24 March 2017

Global Rates Weekly Headline Roulette Treasury Auction Preview: Steady as She Goes Treasury will auction a combined $101bn next week, selling $26bn in 2s on Monday, $34bn in 5s on Tuesday, and $13bn in reopened 2yr FRNs and $28bn in 7s on Wednesday. With $81.4bn in securities maturing at monthend settlement, net cash raised at the sale will total $19.6bn. There will also be $13.6bn in SOMA holdings maturing, with the Fed adding on $3.5bn to 2s, $4.6bn to 5s and $3.8bn to 7s and $1.7bn to FRNs. The market has pushed yields lower in their range amid considerable uncertainty and lack of clarity on tax cuts and stimulus plans. Despite the rise in uncertainty pertaining to Obamacare reform, however, the market has not substantially priced out rate hikes for 2017. In fact, Fed funds futures are still pricing in roughly 50% odds of a June rate hikes and an additional 1.5 rate hikes in 2017. Investment fund demand at auction has rebounded in recent months, likely helping to support demand for the coming week's auctions. 

2s: The 2yr part of the curve looks attractive both outright and on the curve, with the market continuing to price in just around 1.5 hikes in the rest of 2017, we see 2s as relatively fair on an outright basis. The 2yr sector has nevertheless richened on the curve, making the sector less attractive. Averages suggest a stop on the screws and 53% buy side takedown as indirects get 40% and directs get 13%.



5s: Averages suggest a modest tail for 5s, with only one of the past six auctions stopping through the screens. We believe that 5s trading in the proximity of 2% should continue to draw end-user demand, suggesting the need for some pre -auction concessions. Averages point to a 67% buy side takedown (62% to indirects and 5% to directs).



7s: The 7yr point has seen some support over the past few months, with auction averages suggesting a stop 0.5bp through the screens and 77% buy side takedown (66% directs and 11% indirects).

Watch US breakevens as they drift below 2%

index was up 0.7% on the quarter after giving up a bit of earlier gains in March, through Mar 24 (Figure 1). Consequently, we expect pension managers to lighten up on their global stocks holdings and add to domestic bond portfolios going into quarter-end. Our model estimates that U.S. defined benefit funds will need to add about $9 billion in bonds versus roughly $13 billion outflows from equities.

March 27, 2017

Rate Strategy

Rates Express

Modest Quarter-End Pension Rebalancing, as Bond Yields Retreat A long dispute means that both parties are wrong -- Voltaire

Bull or bear? Reflation or dis-inflation? The first quarter of 2017 has had its fair share of heated disputes. But there is no disputing that keeping things in balance is an important part of a pension manager’s job at many private and public schemes. Come quarter- or month-end, they often need to shift some money around between fixed income and equities to stay close to the pension’s long-term asset allocation targets. As Q1 2017 draws to a close, we expect a modest rebalancing by defined benefit pensions as the recent big retreat in Treasury yields from their mid-March highs has helped to narrow the gap in returns between stocks and bonds in pension portfolios.

We project $13 billion outflows from global equities, $9 billion inflows in bonds Domestic equity performance in Q1 turned out to be a case of “bigger is better”. Large cap stocks charged ahead in Jan-Feb returning 5.2% in the quarter, while small cap stocks are flat in Q1 after they faltered in March (Figure 1). Global equities performed more consistently generating strong returns for pension portfolios. At pixel time, international developed index is up 7.2% in Q1 including 2.4% in March, while EM equity index jumped a whopping 12.4% in Q1 including 3.3% in March (Figure 1). In contrast, investment grade bonds have produced only modest gains in Q1. The broad U.S. bond market

Taking a more granular look, we estimate pensions may need to pare U.S. large cap portfolios while increasing their domestic small cap holdings, both by about $5-6 billion. EM stocks, which have outshined domestic equities by a wide margin both in March and Q1 thus far, may see about $6 billion of outflows. Strong performance of global developed equity indices may lead to about $7 billion in quarter-end sales, according to the model (Figure 1). The $9 billion or so of potential buying in fixed income may initially focus on Treasury futures, specifically TY and US contracts. Spare balances remaining after net selling of stocks and buying of bonds may be used to satisfy pensions’ “capital calls” (i.e. funding checks to retirees) and proportional allocations into the newly-rebalanced portfolios. Please refer to the table in Figure 1 for full detail.

… Historical context The roughly $9-13 billion pension rebalancing between bonds and stocks is relatively modest in a historical context. Recall that our model projected about $20-25 billion in rebalancing flows in Q4 2016. Note, that rebalancing needs may jump or diminish quickly if markets become volatile in the remaining days before quarter-end. Side note: company pensions enjoy more improvements after tough run

… Company pension solvency ratios have enjoyed a considerable improvement since the big turnaround in equities and interest rates began after U.S. elections. Higher stock prices and Treasury yields had brought some relief to both the asset and liability side of pension “balance sheets”. It appears that pension solvency ratios continued to improve in Q1 2017. We plan to follow up with a more detailed update on the health of U.S. pensions when companies’ 2016 10K statements become available in Q1.

March 27, 2017

Rate Strategy

Rates Express

Treasury and TIPS Investor Month-End Shopping Cart Politics, Central Banks, Global Flows Drive U.S. Curves and Relative Value April Fool’s day may be nearly upon us, but there is no fooling around with the need for a month-end adjustment in sovereign bond portfolios. The ritual of benchmark extensions and reinvestment of principal and coupon proceeds is upon us. As usual, we aim to help Treasury and TIPS portfolio managers seek (relative) bargains and implement market views. G10 yields become less correlated, as U.S. curves should continue to flatten The FOMC delivered a hike in March indicating, in our view, that something resembling a conventional tightening cycle may be upon us. U.S. front-end appeared well set up for the Fed’s move thanks to the coordinated effort by the key policymakers to get the market-implied probabilities up fairly quickly. We continue to focus on the two key themes in the sovereign bond markets, which we think have been further validated by the Fed’s move in March. First, we expect G10 yields to de-correlate after they moved largely in tandem prior to the November election for most of 2016. Divergence in monetary policy between key central banks and early signs of a handover to fiscal policy in some of the largest economies should weaken correlations between G10 yields. In fact, Figure 1 shows that 10y yields jumped by 15-18 bps in Germany and Italy in March, while the 10y Treasury yield has declined. Even the reaction to the FOMC’s move differed widely between G10 markets: the 10y Treasury yield dropped 24 bps, while 10y Bunds and Gilts barely moved (Figure 1). Second, we have suggested all along that even a slightly more hawkish tilt at the Fed should help U.S. intermediate curves to flatten. Following the March 15th hike, the Treasury 2/10 has flattened 13 bps in spot. We expect the FOMC to tighten again in June and December, followed by three more hikes in 2018. Consequently, we look for intermediate curves to still flatten a bit more than forwards in 2017. In addition to the FOMC, demand from foreign investors for U.S. fixed income in the 7-10y sector should give these trades a boost, in our view. For more in-depth discussion, feel free to peruse Rates Explorer, “Is Le Pen Mightier than the Sword?”, March 7, 2017, and Rates Express, “Third Time is a Charm?”, March 15, 2017.

… Quarter-end pension activity may give

bonds a modest boost Domestic large cap stocks have returned about 5% in Q1, while international developed and EM equity indices are up about 7% and 12% respectively. In contrast, investment grade bonds have produced only modest gains in Q1 with the broad U.S. investment grade index up less than 1%. Consequently, defined benefit pensions may need to sell stocks and buy bonds to rebalance their portfolios. Our model points to a fairly modest $9 billion buying needs in bonds, as of U.S. market open on March 27. The bulk of initial rebalancing-related activity may take place in the liquid futures contracts. Keep in mind that we are still four trading days away from month-end; large moves in the underlying markets can quickly boost or diminish pension rebalancing needs. More details can be found in Rates Express, “Modest Quarter-End Pension Rebalancing, As Bond Yields Retreat”, March 27, 2017

… Clients determined to maintain exposure in

the front-end should consider a “barbell” by overweighting the 10y sector. This way, the portfolio can clip handsome carry and rolldown in the 1-3y area, while exposure to the 10y sector should help mitigate the scenario if the curve flattens following the next FOMC tightening move. In fact, 2/10 flattener would have worked out nicely as a hedge against rising short-term rates after the March 15 FOMC hike, as we discussed in the previous sections. Looking past the front-end, 2022-2024 issues seem attractive to real money mandates with intermediate benchmarks. They can withstand 25-30 bps increase in yields over six months and still break even (Figure 2). In addition, a steep rolldown in asset-swapped curves should make this sector quite appealing to real money mandates, including overseas buyers. … As we discussed in the previous sections, the March FOMC appeared to have greenlighted intermediate curve flatteners in the U.S. despite robust initial move in the first several days after the hike, we look for curves to flatten more going forward. Clients who agree with us that increases in 10y yields should be relatively modest in 2017, may look to add

exposure in cheaper off-the-run issues in the 2025-26 bucket and take advantage of the relative value (Figure 9). Old 10s with February 2025 through February 2026 maturities look quite appealing…

March 27, 2017

March 27, 2017

Economics Group Capitol Hill Update: Now What?

Taxing Questions: Corporate Tax Reform and Capex

After the House of Representatives decided not to hold a vote to repeal and replace the Affordable Care Act, what comes next? We expect the focus to shift to a bipartisan bill funding the government beyond April 28.

Executive Summary

A Very Tight Timeline

Economics Group

Special Commentary

Among the various fiscal policy proposals being considered by the current administration, corporate tax reform, including repatriation of corporate profits held overseas, could have meaningful implications for business spending. This special report considers what those reforms might look like and the impact to our forecast for capital spending on equipment and intellectual property. A prior repatriation tax holiday offers a relevant and useful proxy from which to draw conclusions and challenge some the assumptions about the current proposals. We evaluate the Homeland Investment Act of 2004 and the inflows that followed in 2005 and determine that repatriations did not lead to an increase in domestic capital spending (Figure 1). The findings on broader corporate tax reform are somewhat less straightforward. Our own analysis of business spending before and after the Tax Reform Act of 1986 finds that the reform provided a significant boost to capex spending. However, depending on how deductions and expensing are altered, a change to the topline tax rate may not be that impactful to business investment. Moreover, our read of the climate on Capitol Hill suggests there is not a viable path to a complete rewrite of the corporate tax structure and any changes in corporate taxes are likely to be more measured than the sweeping changes proposed during the election campaign. On that basis, a milder reform of the corporate tax code would mean that the implications for business fixed investment spending are not likely to be dramatic. All that said, we do expect the growth rate for capital expenditures on equipment and intellectual property to pick up in 2017, but that is more attributable to other drivers of business spending, including rising profits, greater business optimism and stronger final sales (Figure 2).

Potential Issues in Passing a CR When Can We Expect Movement on Tax Reform? In order to start tackling tax reform legislation, a new budget resolution needs to be passed for the upcoming 2018 federal fiscal year that begins in October. If agreed to by the House and Senate, this second budget resolution will setup the budget reconciliation process to allow a tax cut bill to move though the Senate with only 51 votes as opposed to the usual 60 votes required to move forward on legislation. With the budget debate taking center stage, we expect this new budget resolution to be passed sometime in May. As we wrote back in January, we expect tax cuts rather than tax “reforms” to be enacted. The difficulty in forging an agreement within the Republican caucus was highlighted last week and will translate into the need to get tax cuts enacted. Tax reform discussions encompassing both the personal and corporate tax codes would likely take months or even years. In order to get legislative points on the board, we think Congress and the Administration will agree to nondeficit neutral tax cuts to show some progress on their legislative agenda. In our view, the earliest tax cuts would be enacted is likely late May or June given the need to craft a bill and work through the negotiation process. After the House Freedom Caucus successfully blocked the ACA repeal/replacement bill, we have downgraded our assessment of tax cuts being enacted to a 65 percent probability. Should the tax reform debate spill over to the post-August recess, we would become more skeptical that any tax policy changes would be enacted until after the 2018 midterm elections.