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StreetStuff Daily June 29, 2017

BECAUSE: The way to get good ideas is to go through LOTS of ideas, and throw out the bad ones…

28 June 2017

US May advance good trade deficit narrows; Q2 GDP tracking at 2.4% Wed 6/28/2017 9:08 AM

May Advance Trade and Inventories Stephen Stanley Chief Economist

Early estimates of trade and inventories for May provide new data to help fine-tune Q2 GDP tracking estimates. I am revising my projection for Q2 real GDP growth down by two tenths based on these numbers, from 3.7% to 3.5%. … Meanwhile, inventories rose in May at the wholesale and retail levels. In fact, both wholesale and nonauto retail stocks advanced by 0.3%, more or less reversing April declines. As we start to flesh out the inventories data for the quarter, it looks like we may see an acceleration from the unusually soft Q1 reading (when inventories barely rose at all), but the gain may be limited, perhaps adding around half a percent to GDP growth in Q2 after subtracting a little more than that from Q1. Wed 6/28/2017 3:49 PM

Fed Sentinel: The Evolution of the Fed's Treasury Holdings Stephen Stanley Chief Economist

Attached is a piece that runs through the math of the Fed’s balance sheet normalization program for Treasuries. The

bottom line is that the Fed is not going to be able to hit its ceilings consistently in the out-years, so redemptions are likely to extend into the next decade.

…the advance goods trade report was better than expected, showing a narrowing in the deficit on account of solid export growth and weak imports. In addition, capital goods imports, which feeds into our equipment investment tracker, rose more strongly than we had anticipated. Both categories boosted our Q2 GDP tracking estimated. This morning’s report also included inventory data, which also came in higher than expected and now imply no drag on GDP growth from the inventory component. Overall, today’s data boosted our GDP tracking estimate fivetenths, to 2.4% q/q saar after rounding.

28 June 2017

US pending home sales fall unexpectedly in May …On the whole, today’s data were disappointing, but pending home sales remain at levels consistent with a modest improvement in the housing sector in 2017 (Figure 1). Figure 1: Modest recovery in pending home sales

28 June 2017

Pending Home Sales Contract Activity Misses; Second Consecutive Month of Y/Y Declines Bottom Line Pending home sales came in at -0.8% m/m in May, below our estimate of flat m/m, which was lower than consensus of +0.5% m/m. Following three straight months of sequential declines, the seasonally Adjusted Pending Home Sales Index is down 3% from recent peak in February. This slowing is consistent with the modest decline in the Buyer Traffic Index seen in our May Barclays Real Estate A.G.E.N.T. survey (Link - Strength Erodes on Inventory and Affordability Headwinds; published on 6/5), in which agents discussed inventory and affordability headwinds. On a y/y basis, contract activity came in -2%, marking the second consecutive month of low-single-digit declines in growth. May existing home sales bounced back to +low-single-digit range y/y, and this contract reading suggests downside risk to closings growth in June/July.

28 June 2017

US Money Markets

Replacing Libor: Next steps Last week, the ARRC voted in favor of a new benchmark interest rate based on an expanded overnight Treasury GC rate. While the new benchmark has several important advantages over Libor, the phased transition from Libor will take years and create new costs and risks.

Wed 6/28/2017 4:14 PM

Lyngen/Kohli BMO Close: Belly Up (attached) …With supply out of the way, we’re focused on

data and month-end, which often entails a drift lower in yields on the last day of the month as structural buyers come in to satisfy duration needs. With a roughly average 0.07yr index extension expected, we’re looking for buying to be much

more focused on the last day of the month as opposed to having a more considerable effect on yields earlier in the week (as is common for aboveaverage extension months). The data will be relatively heavy in the US with GDP and claims out, but we’ll also get a read on the strength of consumption and some indication of whether the data continue to show stability or whether there will be further underperformance. Tactical Bias: …We’re still watching the curve more closely than outright levels as a result for a better read of the market’s thinking. While the outright moves are certainly important, the bounce within 20bp of 2% on 10-year yields doesn’t offer a great deal of new insight on the market’s assessment of legislative progress or the Fed’s newly hawkish tone. Rather, the shift in the yield curve, with 5s/30s bouncing between a tactical steepening and a potentially seismic flattening holds a bigger clue to the market’s view of economic outcomes. We’re watching 5s/30s levels below 95-93 bp and a close through those levels on Friday would indicate that such a shift is afoot while a bounce steeper may delay the reckoning to a later date. The catalyst for such a move could easily be a further decay in the term premium from what we saw just a few months ago and it wouldn’t surprise us to see long-end term premiums drift back towards the lows of last year. …Inflation will be a key release in the coming days

in making that determination and though it’s less likely to be a surprise, inflation and inflation expectations have still come into focus as the “missing pieces” of the Fed’s data puzzle. Thus far, the Fed has been able to use the fig-leaf of still high core levels to argue for additional tightening, but a continued slowdown in YoY inflation or a more material indication of slowing in PCE would likely diminish their ability to keep that narrative intact. It’s one of the reasons we believe the market will focus on it even more heavily than usual. The other side of this coin is that as the Fed jawbones rates higher, if inflation begins to crack, real rates will rise more sharply than the Fed intended, raising the risk of a quicker deleveraging.

28 Jun 2017

Economic Desknote US - US: What’s the yield curve telling us? 

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The US yield curve has flattened, but so it should in a tightening cycle. We are a long way off from flat, even before we allow for the effects of QE, which primarily affects the long end. The 2y tells us that most of the new information about the Fed’s intentions came around last December’s rate hike, a bit in March and little since. The 10y risk-neutral rate shows the market reluctantly accepting a nominal terminal fed funds rate above 2.5%. The term premium says it does not buy the rationale for this. The term premium has largely been driven by inflation expectations – the market’s view of equilibrium real rates remains just above zero. It doubts the Fed’s inflation story.

Chart 1: US yield curve and recessions (%)

Chart 2: US 2-year yields and fed funds (%)

… To sum up, this is what we think the movements in the shape of the yield curve are telling us.  Short rates are rising; this always flattens the yield curve, but the flattening since January has mostly been driven by the long end.  We are quite a long way from a flat curve that might constitute a warning signal, especially if we allow for the flattening effects of QE.  The market doubts the Fed can deliver what it has suggested – not because the market forecasts a significant slowdown, but because it does not buy the Fed’s inflation story.  If the Fed believes its inflation narrative, there is no reason to hold off delivering the one further hike it has pencilled in for this year, which we believe will come in December.

US Rates at the Bell June 28th, 2017

Trader’s Tab  The “Sintra Summer Squeeze”? With the BoE’s Carney throwing his hawkish cap in the ring this morning, it would appear that the narrative comprising a volbereft negative net-supply summer in EU fixedincome markets may be at risk with a coordinated push from global CB’s to ‘normalize’ on the basis of recalibrated goalposts.  Rate-of-‘Flation: While less disinflation doesn’t equal reflation, the argument can be made that there are signs that the rate of change of inflationary inputs may have troughed in the last week. This is suggested by a bullish reversal in oil and a number of relative strength inflation proxies (Copper v Gold, Fins v Staples, AUDJPY).

Recap & Discussion:

US rates endured a choppy range-expansion day which saw TY’s trade ~1.5mn contracts, though admittedly more than 35% of volume traded before the NY session start. Rates closed modestly higher, though reversed well off the

steep losses seen overnight before an ECB sources article threw cold-water on Draghi’s “reflationary” pivot from Sintra. This drew some discretionary dip-buying from the real-$ community and fast-$ profit-taking. The BoE’s Carney counter-balanced the impact on G4 fixedincome however, joining his hawkish banking compatriots, stating that “some removal of monetary stimulus is likely to become necessary if the trade-off facing the MPC continues to lessen and the policy decision accordingly becomes more conventional”. The thematic flows on the day were mostly expressed on the curve however, with 2s10s and 2s30s spreads steepening the most since early-March. Inflation performance was a decent component of this move, with 2y and 5y breakevens now >10bps off the mid-June lows. This was helped by a +1% oil move (now confirming a bullish pivot after breaking back above the May lows, fig. 1). We also see curve positioning as a contributing factor, with yesterday’s open-interest change in futures showing TU and FV OI higher (suggestive of new shorts), while long liquidation likely drove TY prices lower with a fall of $2.1mlm in DV01. Per our RPM measure, we also noted that as of yesterday’s close, we had net longs at +0.9 and +2.4 across TY and US contracts (long duration and in flatteners). As we discussed Monday, the CFTC data also showed Friday that TU-TY Spec flattener exposure was at an extreme >3-signma level on a 3y Z-score. On a cross-asset basis, despite limited fundamental evidence, we’re beginning to see some confirmatory technical signs that reflationary rotations are gaining steam into quarter/month-end. Seemingly despite the Italian HICP and German import price drops this morning, both industrial commodities and inflation proxies are showing signs of relief in line with the oversold bounce exhibited in breakeven space, while the largest daily gains in equities since mid-May can’t exactly be ignored. In terms of duration sensitivity, we think that the rebound in iron ore and copper are the most important to gauge in determining the extent of this reflationary relief. As we show in (figs 2-4),

both Iron ore and Copper are showing 30-day r^2’s greater than 0.65 to TYs and 2s10s curve, and both look technically sound, breaking multimonth downtrends in the last 5 sessions. This may have Chinese origins (given Iron Ore delivered to Qingdao is +5.6% in the last 5-days after the PBoC’s liquidity injection last week). In (figs 5-8), we also show that traditional duration leading indicators (copper/gold ratio, XLF/XLP relative strength, and AUDJPY) are giving off some bearish inference.

28 Jun 2017 14:04:17 ET

RPM Daily New Shorts and Steepeners In the US, the flow was dominated by selling in the belly and back end into the sell-off; however,

flows were relatively constrained. Only $7m DV01 added to the short base (through long liquidation and new shorts), while leverage accounts placed tactical 2/10y steepeners. Overall the positioning remains neutral with long futures (at 0.7) offset by short cash (at -0.5). Meanwhile 5/30y flatteners, long Eurodollar reds and short dollar remain intact and mildly in profit. 28 Jun 2017 13:58:39 ET

US EIA Petroleum Statistics Oil inventories continue to move lower in the US, while Asian markets show constructive near-term signs too 

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Oil prices look set to continue moving upwards this week as money manager net long positioning in crude oil futures and options reached near all-time lows. Meanwhile, US inventories data continue to show ongoing rebalancing, though Storm Cindy added noise to the picture. Outside the US, Japan’s crude stocks fell 8-m bbls w/w and this is before refinery runs head higher seasonally; Singapore simple refinery margins remain strong; and Chinese apparent demand growth came in robustly for May. Commercial crude oil inventories rose 118-k bbls to 509.2-m bbls; total US crude inventories, including the SPR, drew 1.3-m bbls to 1,192-m bbls. Gasoline inventories fell 0.9-m bbls to 241-m bbls. Diesel inventories fell 0.2-m bbls to 152-m bbls. Total crude and product inventories excluding NGLs drew 7.4-m bbls to 1,843-m bbls, having averaged draws of 2.9-m bbls per week since the Feburary peak.

Deutsche Bank 29 June 2017

FX Special - three big new themes in markets

1. ECB liberation – President Draghi’s speech on Wednesday was important not because he marked a hawkish shift to policy but because he implicitly signaled that the ECB is not as concerned about low inflation any more: it is now considered temporary. The language shift is critical because it “liberates” the euro, disinflationary strength in the currency may now matter less for the ECB. This language shift coincides with another regime change that has been evolving in recent months and is even more important: the complete breakdown of EUR/USD with rate differentials suggesting the ECB was losing control of FX anyway. Both these observations are critical because they suggest that the euro can strengthen despite, not because of higher bund yields. In fact, the more the euro appreciates the more ECB tightening will be slowed. The key driver of euro strength is not ECB hawkishness but medium-term rebalancing of structural post-crisis underweights in European assets. The ECB may not able to do much about it. 2.Fed zombification – in the meantime we have another regime shift in play reflected in the market persistently ignoring Fed tightening in both action and words. The key to understanding this behavior is that unlike other central banks the Fed is approaching it's own assesment of the nominal neutral rate at 2%. While this is not priced for next year, the market is already priced for a terminal rate slightly below 2% further out the curve. Even if the tightening happens sooner rather than later, the crux of the argument is that unless the market believes the Fed is running behind the curve (eg. US inflation acceleration) tightening will continue to look more like easing: the more the terminal rate approaches, the higher the odds of a Fed “pause” or “time out” until the productivity or inflation pictures improve more. 3.Global co-ordination – the final shift emerging is a co-ordinated shift from developed world central banks in a more hawkish direction, all apparent in rhetoric from the ECB, Fed, Bank of Canada, Bank of England and likely others in coming weeks. This global co-ordination was implicitly confirmed by Draghi’s little-cited comment in the central banker Sintra panel yesterday where he noted the importance of G20 central bank co-ordination in keeping market volatility low. The implicit message here is that if all central banks sound hawkish at the same time then divergence, and therefore FX volatility, will stay low. The problem with this convergence however is that the Fed is already in tightening flight mid-air with other central banks just about to take off the runway. With the next big question for the market the timing of a Fed "landing", hawkish co-ordination in such an environment can do serious damage to the dollar.

George Saravelos

Developments over the last two days provide numerous signals to argue for three important regime shifts in markets away from the low volatility equilibrium.

In sum, the return of market volatility is likely to persist and the dollar has potential to weaken more. There is more time for these big themes to run.

28 June 2017

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US Economic Notes Headwinds to exports are fading 

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The advance international goods trade balance narrowed modestly more than expected in May and is averaging -$66.7 billion through the first two months of the quarter. This compares to an average of -$66.3 billion in Q1. However, as the chart below illustrates, the yearover-year change in the nominal trade-weighted dollar leads the trend in exports by one quarter. The ongoing slowdown in dollar appreciation is a meaningfully positive development for the external sector. Retail and wholesale inventories also improved in May. Recall that inventories lopped off 107 bps from Q1 growth. Hence, we continue to expect a modest positive contribution from stockpiling in Q2. Tomorrow's final revision to Q1 real GDP and Friday's personal consumption data will sharpen our estimate for current-quarter output. Thus far though, growth appears to be tracking close to 3% in Q2.

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Another popular market claim is that the Fed has given up on the 2% inflation target, evidenced by its blasé reaction to soft recent inflation data. However, a standard reaction function actually suggests both that the recent inflation and unemployment news should have roughly offsetting policy implications, and that the policy rate is in fact still somewhat too low. Does this mean that Fed officials will need to make a concerted effort to “talk up” the 10year rate in coming weeks? We doubt it. While the FOMC likes its policy actions to be mostly priced when taken, Fed officials are usually less concerned that long-run market interest rates—which reflect many factors besides clarity about the reaction function— conform to their own views.

Exhibit 1: Financial Conditions Have Eased, Not Tightened

Figure 1: The dollar drag on exports has largely receded

28 June 2017 | 2:30PM EDT

Oil: Still searching for the equilibrium 

28 June 2017 | 12:19PM EDT

US Daily: Is the Fed Making a Policy Error? (Mericle) 

The idea that the Fed is making a hawkish policy error has become a popular market theme, with many investors pointing to the recent flattening of the yield curve as evidence. This thesis implies that the Fed has caused an excessive tightening in financial conditions that has in turn caused the economy to slow more than intended. But so far, neither of these has happened.

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The fast ramp-up in shale drilling and the unexpectedly large rebound in Libya/Nigeria production are on track to slow the 2017 stock draws. This creates risks that the normalization in inventories will not be achieved by the time the OPEC cut ends next March. We expect this will leave prices trading near $45/bbl until there is evidence of (1) a decline in the US horizontal oil rig count, (2) sustained stock draws or (3) additional OPEC production cuts. Given that the market is now out of patience for large stock draws and increasingly concerned about next year’s balances, we believe that price upside will need to be front-end driven, coming from observable near-term physical tightness. Cyclically, we believe that the balance of risks is nonetheless shifting from the downside to the upside: (1) global inventories are still drawing and we continue to forecast a deficit this year, (2) net long positioning is back to its February 2016 low

level, (3) production disruptions are at their lowest levels in 5 years and skewed to the upside, (4) OPEC can (and in our view should) act and cut more than what Libya/Nigeria are adding, (5) our demand forecast remains above consensus expectations, and finally (6) we have yet to see if the US service sector can convert this unprecedented increase in drilling into production and what inflationary pressures this will create. As

a result, while we are lowering our 3-mo WTI forecast to $47.50/bbl from $55/bbl previously, it remains above the forward curve. 

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Structurally, however, ongoing productivity gains for shale and cost deflation elsewhere corroborate our $50/bbl long-term WTI price anchor. While this leaves risk to our 2018-19 $55/bbl forecast squarely skewed to the downside, the shale breakeven discovery process is still a work in progress given the opposing forces of productivity gains, cost inflation and the dynamic cost structure of shale. This leaves us cyclically bullish within a structurally bearish framework: the near-term price risks are now increasingly skewed to the upside while the low velocity deflationary forces of the New Oil Order are still at play.

29 June 2017 | 5:43AM EDT

Commodity Watch: Three rules of commodity investing The rules, at first violated, now point to going long 1) The 15% collapse in commodity prices from their early Feb 2017 peak has been almost entirely supply driven, taking our long S&P GSCI trade recommendation from +10% through its stop in record time. While some of the factors behind this sell-off, like Libya and Nigeria’s return and weather’s impact on crop yields and natural gas demand were unpredictable, we did fail to appreciate the velocity at which the ‘self-defeating’ commodity supply response to higher prices occurred. In energy it was shale, but it also occurred in copper from scrap. In addition to the velocity of supply, we also underappreciated the velocity of investment in commodities where positioning swung to record long, incentivizing the supply response, then to near-record short in many markets in matters of weeks. The exception was metals that remain modestly long, which underscores that this commodity rout was not about demand but

rather about supply concerns in energy and agriculture. 2) The return of Libya and Nigeria do warrant a change in near-term oil forecasts. As Damien Courvalin published (here), we are reducing our 3month target on WTI to $47.50/bbl from $55/bbl. However, we believe the balance of risks is shifting to the upside from current price levels. This suggests that while the trading range is probably lower than we initially thought, we are likely at the bottom end of that range now and at current price levels the asset class looks attractive. We are now forecasting 3-month and 6-month ahead returns of 3% and 10% respectively. We maintain our overweight recommendation as inventories are still drawing in many markets and are expected to through year-end. Positioning is consistent with the depths of the bear market in 2016. Supply risk premiums have been completely removed in oil and agriculture. The oil market is pricing the lowest level of oil disruptions in 5 years. OPEC can (and in our view should) act to accommodate what Libya and Nigeria are adding. Finally, global demand growth still remains intact, and we are maintaining our above consensus forecasts. 3) But this still leaves the question of how did we (and the market) get it so wrong? The answer to this question lies in three rules of commodity investing that were underappreciated by ourselves and a large part of the market. As we explain in more detail below, the rules are: 1) commodity markets are not anticipatory assets and pricing in expectations will likely prove self-defeating; in other words, trade prompt fundamentals and don’t confuse deferred balances with reality; 2) don’t speculatively trade commodities beyond their supply cycle; in other words, don’t wait for deferred fundamentals to catch up to the market as prompt fundamentals will win; and 3) commodity timespreads do not lie, at least through the duration of the supply cycle, and as a result provide a very good read on prompt fundamentals. However, further out beyond the supply cycle, prices and spreads are markets for risk capital and hedgers, and as a result, deferred spreads offer little information on deferred fundamentals. 28 June 2017 | 9:20AM EDT

USA: Trade Deficit Narrows on Firming Export Growth; Inventories Rise BOTTOM LINE: The advance economic indicators report showed an increase in wholesale inventories and a narrower goods trade deficit in May. We left our tracking estimate of Q2 GDP growth unchanged at +2.3% (qoq ar).

June 28, 2017

JEF Economics

Daily Market Crib Sheet … St. Louis Fed President Bullard will speak about the US economy and monetary policy at the Official Monetary and Financial Institution Forum's city lecture in London. - Bullard has said many times that he does not think that further rate hikes will be justified over the next few years. However, he does favor moving forward with the process of normalizing the balance sheet.

June 28, 2017 Treasury Market Commentary

Daily Commentary, 6/28 U.S. rates continued to be driven by big moves in overseas markets Wednesday triggered by global central bank surprises, with the Bank of England and Bank of Canada taking their turns Wednesday after the major ECB-driven repricing Tuesday, leaving Treasury yields mixed but the curve substantially steeper again along with further steepening in Europe and the U.K. and a smaller catchup bear steepening in Japan overnight. Better than expected early reads on May international trade and inventories boosted our Q2 GDP estimate to 3.0% from 2.7% so there was some domestic support for futures markets shifting to pricing the likelihood of a third rate hike this year for the first time since early May, but U.S. markets were again predominantly following international policy signals, which have driven quite a large drop in the broad dollar index this week to a new low for the year. On top of that, a surge in stocks (+0.9% for the S&P 500) back to not far from record highs helped keep U.S. financial conditions very easy versus the, so far, limited rise in yields from the recent lows. …Perhaps this wasn't the best venue for Draghi to send any such signals, but Bank of England Governor Carney, for his part, took advantage of his

appearance on the same panel to sound less dovish, seemingly signaling more sympathy with the hawkish recent tilt from other BoE communications (closer than expected 5-3 MPC vote and hawkish minutes and comments from BoE Chief Economist Haldane) that he had pushed back against last week. In his introductory remarks at the panel, Governor Carney said that when the "MPC last met earlier this month, my view was that given the mixed signals on consumer spending and business investment, it was too early to judge with confidence how large and persistent the slowdown in growth would prove," but "Some removal of monetary stimulus is likely to become necessary if the trade-off facing the MPC continues to lessen and the policy decision accordingly becomes more conventional." That sounded like an incremental shift from his comments last week a few days after the surprisingly close 5-3 MPC decision that "Different members of the MPC will understandably have different views about the outlook and therefore on the potential timing of any Bank Rate increase. ... From my perspective, given the mixed signals on consumer spending and business investment, and given the still subdued domestic inflationary pressures, in particular anaemic wage growth, now is not yet the time to begin that adjustment." In response, U.K. markets moved towards pricing August as potentially a live meeting for consideration of a BoE rate hike, with about a 20% chance of a hike now priced, and steepened the future path of policy rates, driving heavy losses in intermediate yields. The Sep 17 short sterling futures contract lost 2 bp to 0.405%, Dec 17 lost 4 bp to 0.49%, and Dec 18 7 bp to 0.71%, the 10-year Gilt yield rose 9 bp to 1.17%, 2's-10's steepened 4 bp for an 8 bp twoday rise, and the pound jumped to $1.293 from $1.281, a three-week high.

…A lot of activity continued to be crosscurrency in swaps and Treasuries, most notable of which Wednesday was block buying of long-end Treasury futures versus selling Canada in almost record volumes for the Canada side. According to the TMX, a 9098-contract block sale of Canada bond futures was the second largest ever after a trade in March 2008. Along with cross currency buying, our swaps desk saw generally better real money receiving in U.S. rates versus fast money buying spreads in the belly of the curve. Spreads along the curve were up slightly on the day, which for the 30-year (-30.2 bp v. 31.5 bp) meant another new high since 2015 after a 12.5 bp rise since June 12 ahead of the Treasury's regulatory report. In the past couple days that trade seems to have paused for now. Buying spreads further in on the curve in the belly was more of a seasonal trade. Ahead of

quarterly earnings reports next month, there shouldn't be any swapped bank issuance for a couple weeks putting downward pressure on spreads.

June 28, 2017 U.S. Economics: Advance Trade and Inventories/GDP The advance indicators report showed better than expected early reads on May exports and wholesale and retail inventories, boosting the outlook for Q2 growth. We now see Q2 GDP rising 3.0%, up from our prior 2.7% estimate. … We now see net exports adding 0.1pp to Q2 growth instead of being flat, with real exports expected to be up 1.4% instead of 0.7% and real imports up 0.8% instead of 0.4%. Within the gain in overall exports, capital goods exports fell 0.4% and within the drop in imports capital goods imports rose 2.3%. That points to better growth in domestic investment. We see equipment investment gaining 3.5% in Q2 instead of 2.0% and overall business investment 3.1% instead of 2.4%.

June 29, 2017

FX Morning Daily Commentary, 6/29 The EUR rally has come early. Our expectation for EURUSD to rise towards 1.19 next year has been met with some scepticism regarding the magnitude of the move. Long term investors who have been structurally short the EUR for many years may need to now start shifting positions. At the same time, Eurozone equities are seeing foreigners continuing to buy without an FX hedge. For now we see EURUSD rallying towards the 1.1570 level and any setbacks thereafter providing opportunities to re-enter the trade. Today the best strategy for us is to buy EURJPY, helped by the BoJ remaining very dovish. US real yields staying relatively low helps global risk assets to perform and the JPY to weaken. All 34 US banks have passed the Fed’s annual stress test, a catalyst our bank analysts were waiting for to see

increased bank lending and outperformance of this sector. Announced share buybacks should also improve risk sentiment, expressed in our FX portfolio via long EM currencies. The Fed highlighting that China’s recorded trade surplus may be larger due to capital flight disguised as tourism outflows may further help the USDRMB rate to stay stable, helping risk. Analysing the ECB reaction. EUR related markets provided strong signals that they agree with the ECB’s suggestion that the economy is moving towards reflation and should start tapering asset purchases soon. For us it was important to note that volatility in markets (BTP spread and Eurostoxx 50 implied) has stayed muted. The BTP-Bund spread has stayed stable over recent days and even come down sharply since the start of the month. EURUSD has developed an inverse correlation with the BTP spread. The bond market reaction is more remarkable considering the release of weaker than expected Italian May CPI of 1.2% (vs 1.4% expected) and coming down from 1.6%. Today Germany will release regional CPI data. What convinced traders to hold on to BTPs has been the strength of Italy's PMI readings, its rallying equity market under the lead of financials and EMU showing increased will for reform. For instance, we saw signs of increasing will for reform when the Commission released yesterday its list of centralised tax takes feeding the European budgets. Optimists could interpret such moves as preparing for a common EMU fiscal body.

Japanese Have Been Buying Foreign Assets, See JPY weaker

Across

JUNE 29, 2017

FIXED INCOME DAILY CENTRAL BANK COMMUNICATION BREAKDOWN Market Update Central bank communication breakdown. Wednesday saw more central bank-induced volatility. Yields were under upward pressure at the European open, as Draghi’s comments continued to drive fears over an early tapering of ECB bond purchases and as the Fed pointed to overstretched asset prices (see Wednesday’s European FI Daily). However, suggestions from the ECB that the market had “misjudged” Draghi’s comments resulted in a sharp rally in EGB prices, back to opening levels for Bunds, while peripherals outperformed. Gilts also rode the coattails of this move in EGBs, only to be struck down by comments from BoE Governor Carney that some removal of BoE stimulus may be necessary. With consumer spending expected to slow, this was conditional on rising business investment. However, the market viewed it as cutting a distinctly more hawkish line than last week’s suggestion that “now is not the time to be raising rates.” 

Central bank communications certainly appear quite haphazard at the moment, but it is also the fault of the market for over-interpreting many of these comments. Already slightly thinner markets, as summer approaches and ahead of quarter-end, are driving some large price swings. There is a general feeling that the world is reverting to a more ‘normal’ environment, but it remains a long unwinding road. 

Graph 1: Bloomberg Economic Surprise index

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the Atlantic, however, there are no signs of rolling back on the hawkish tone. Fed Chair Yellen surprised the market by noting earlier this week that the “economy is strong enough to withstand higher interest rates”, and that valuations in equities and other risky assets are “somewhat rich”. These hawkish comments compound similar observations from other Fed officials: Fed Vice Chairman Stanley Fisher calling for “close monitoring” of risk appetite and noting that P/E ratios are near the top of historical levels, or SF Fed President John Williams on how equities are running on “fumes”, for example. These are not new observations; in the May FOMC minutes, the Fed highlighted that "[...] asset valuation pressures in some markets were notable. Although these assessments were unchanged from January’s assessment, vulnerabilities appeared to have increased for asset valuation pressures, though not by enough to warrant raising the assessment of these vulnerabilities to elevated”. Nevertheless, the concerted effort in recent days by several Fed officials to emphasise these risks may point to an increasing level of discomfort with the current dovish pricing of the Fed. JUNE 29, 2017

FX DAILY ALL THE KING'S SOLDIERS AND ALL THE KING'S MEN Apparently, ECB President Mario Draghi's comments about reflationary forces replacing deflationary ones were mis-interpreted by markets and were intended to be more balanced. A case of ham-fisted communication that argues for less forward guidance by policy-makers? Maybe, though I think the strategy on both sides of the Atlantic, which is to only change policy settings after ensuring markets won't be surprised, has merit. And more importantly, will continue. What I don't think, is that you can 'unsay' things by expressing surprise at the market reactions, any more than the king's soldiers could put Humpty-Dumpty back together again.

…All of this means that the dollar gets less support from US interest rates. A stronger dollar needs higher yields now than it did before, because the rest of the world is moving. And what we have in the US is mixed economic data, a lack of inflation (it'll be the

PCE deflator we focus on tomorrow) and rising equity prices. More dividends and buy backs help keep the equity party going, which surely also help underpin Treasury yields, but won't do that much for the dollar.

reflecting rebounds in auto and capital goods but pulled down by food exports that had looked exaggerated in April. Imports fell 0.4% after a 1.0% rise, with most categories reversing prior gains but capital goods imports continuing to rise. 28 June 2017

UK Economic Comment Removing our forecast of further easing in the UK

28 June 2017

US Economic Comment Q2 GDP tracking 2.6% on May inventories bounce Q2 tracking +0.3pt to 2.6% We have raised our tracking estimate for Q2 real GDP to a 2.6% q/q annual rate from 2.3%. One important element in our earlier tracking estimates was the drag from falling inventories reported for April. But with those declines revised smaller plus inventory rebound in May, inventories are now a slight positive contribution to growth. The merchandise trade figures were close to what we had allowed for. Rebound in wholesale and retail inventories erases the inventory drag Retail inventories rose 0.6% m/m in May, and Apr was revised to -0.4% from -0.5%. Wholesale inventories rose 0.6% in May, and Apr was revised to -0.2% from -0.3%. With strong consumption, the inventories rebound suggests that the Apr decline was the unplanned result of rising demand. That is probably a positive signal for output. The inventory build that we now show in Q2 is not large. Inventories appear only to be edging up, and inventory investment adds only 0.1 pct pt to growth. However, relative to the 0.3 pct pt drag we had factored in, the change in contribution is 0.4 pct pt. We had highlighted that drag as a risk to the forecast because it was at odds with our general expectations for inventories and because it was based just on the one month of data. Even so, the May move was a rapid rebound. Marginally narrower trade gap in May The merchandise trade deficit narrowed to $65.9B in May (consensus & UBSe $66.0B) from a revised $67.1B (revised from $67.6B). Nevertheless, relative to our earlier tracking estimate, trade is now a slightly larger drag on GDP, subtracting 0.5 rather than 0.4 pct pt from growth. Exports rose 0.4% after a 0.3% decline,

We no longer see a rate cut and additional QE being sanctioned by the MPC The emergence of another two active monetary policy hawks, and the first signs that an internal Bank of England MPC member may join them later in the year, have led us to revise our prior forecast of additional monetary easing being approved in November. This change of call is entirely a response to the recent change in tone of several MPC members, and in no way a sign that our expectations for the UK economy have improved. On the contrary, we are increasingly convinced the slowdown seen in Q1 2017 is set to persist and probably intensify over the period to the UK's EU exit at the end of Q1 2019. 27 June 2017

US Economic Comment Core PCE inflation preview 0.0%m/m (with risks of 0.1%) would slow core inflation to 1.4%y/y PCE prices for May will be reported on June 30. We forecast PCE prices down 0.1%m/m and core prices 0.0%. Risk to the forecast for core prices is skewed towards 0.1%—our estimate is +0.04%, right in between a 0.0% and a 0.1%m/m. However, in either case, the outcome still would be further slowing in the y/y pace to 1.4%, well down from 1.8% as recently as February and the slowest pace since late 2015. Broad-based slowing in May, but little new information Our forecast for May has 8 of 13 major components of core PCE inflation below their trend of the past year—a broad deceleration. However, there's not much new in the PCE price report—more than 80% of it reflects data already reported in the CPI and PPI. What would it take to get back to 1.7%y/y this year? Medical care prices are narrowing the core CPI/core PCE wedge Possibilities of revisions

continue to scale into flatteners, in our view, while mandates more sensitive to short-term volatility may look for an entry point on pullbacks. A bounce-back in data or signs of progress on the Trump administration agenda could help re-steepen curves in the near term. For more details and number crunching on the balance sheet normalization analysis, please refer to the Rates Explorer, “Balancing Act,” June 23, 2017.

June 28, 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

…Modest quarter-end pension activity; but watch out for late market moves

At the moment, quarter-end pension rebalancing needs appear to be modest. International developed and EM equity indices are up about 6%-7% in Q2, but they generally get smaller allocations in pension portfolios. The U.S. investment grade bond index rose in Q2 but not nearly as much. Consequently,

defined benefit pensions appear to need to sell about $7 billion-$8 billion in stocks and add $6 billion-$7 billion in bonds at the moment, according to our model, not a significant size of quarter-end flows by historical measures. Our usual disclaimer: if

As hot weather spreads across large parts of the world, the heat is also on for many portfolio managers who need to deal with the tough task of a month-end adjustments 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

stocks and bonds diverge into month-end, pensions may find themselves in a last-minute need to adjust asset allocations in their portfolios. Our readers should stay tuned: we will

More balance, less sheet… can the next Fed move flatten curves even more? It appears that the Fed may reduce its balance sheet quickly. We estimate that the total 2018 decrease could be in the $300 billion-$400 billion range. How will U.S. yields react? The 2013 “taper tantrum” serves up a helpful case study: yield changes in key points of the term structure were mostly proportional to the sizes of the Fed’s purchases in each respective sector (Figure 1). Compared to 2013, we expect a milder reaction to balance sheet normalization: the Fed is projected to buy less than half the amount of Treasuries in 2017 than it did in 2013 (Figure 1). Furthermore, the distribution of the current Fed purchases argues for a modest bearflattening move, unlike the sharp bear-steepener produced by the “tantrum.” Our model shows relative moves around 3 bps-4 bps for 2s/5s and 6 bps-8 bps for 5s/10s in 2017 versus forwards, depending on how aggressively the Fed proceeds with reduction in reinvestments.

June 28, 2017

At the same time, a near-term risk to this view has grown as U.S. curves have undergone a relentless flattening move. For instance 2s/5s in Treasuries has pancaked from 76 bps before the March FOMC to about 44 bps at the pixel time. Patient long-term portfolios should

update the model closer to month-end in case there is a meaningful change in pension rebalancing projections

U.S. Investment Grade Corporate Credit Outlook Q3 2017

Hoping for Carry Market Weight Executive Summary

U.S. Investment Grade (IG) corporate credit spreads are currently close to the tights of the year (112 bps) but remain within our expected target of +/-10 bps this year. A healthy rally at the beginning of the year has given way to a steady ‘lo-vol’ grind as credit spreads remained in an 8 bps range over the quarter. The benefit of last year's aggressive loosening of global monetary conditions has started to fade, while hope for a meaningful fiscal stimulus in the U.S. has been tempered as well. That said, credit fundamentals appear to have stabilized as

corporate profitability has improved. Looking forward, we expect the current environment of ‘lo-vol’ carry to continue with few macro catalysts on the near-term horizon. However , the trajectory of spreads could become more choppy as the summer ends and monetary and fiscal policies return to center stage. Over the course of the year, we expect the YTD range to hold for credit spreads with IG +/- 10 bps and HY +/- 50 bps, but in the near term, the grind should continue . To position portfolios, we recommend credit investors stay fully invested to capture as much carry and residual spread compression as possible, but also strongly recommend moving up in quality where possible to minimize a big macro beta bet and instead focus on more micro trades to drive outperformance. To do so, we recommend remaining Market Weight in IG and prefer to focus on sector and curve strategy. Fundamentals: IG companies continue to run historically high levels of leverage with Non-Financial debt/EBITDA of 3.0x. Q1 earnings came in well ahead of expectations, marking the best earnings season since 2011, and strong earnings growth is expected to continue over the balance of the year. However, while earnings are rising, debt is also rising at a rapid clip, particularly for the lower beta portions of the market. As a result, overall Non-Financial leverage remains unchanged as leverage ex-Energy is expected to converge toward Energy over the balance of the year. Technicals: Demand for IG continues to be robust in H1 2017 with record inflows to IG mutual funds and ETFs, pushing up total assets in IG mutual funds to $2.0 trillion. IG bond issuance has similarly clocked a record pace in H1, but the slowdown in Q2 from Q1 has allowed spreads to continue to grind tighter. Foreign demand has been choppier this year as the cost to hedge USD fixed income positions remains high and the USD has started to weaken. Looking forward, we expect slightly less technical support in 2017 versus 2016 as monetary policy moves tighter and foreign flows decelerate. Valuations: The current spread level of 112 bps is through our year-end spread target of 120 bps. With expectations of modest widening, but still positive excess returns, we believe chasing beta is a low-quality trade and recommend investors move up in quality to take advantage of currently compressed valuations. We favor curve flatteners at the long end as we expect rates to end the year above today’s levels, while we favor curve steepeners at the front end to take advantage of historically flat curves. Key IG Market Risks: Potential risks look asymmetric as hope for fiscal support fades and tighter monetary policy looms. If better growth and/or higher yields result in corporate deleveraging and technical support, then spreads could rally back toward the tight end of the cycle (15 bps tighter). However, if heightened interest rate volatility results in a disorderly unwind of fixed income portfolios, fundamental weakness could erupt with nearly $3.5 trillion of IG debt scheduled to mature in

next five years. This could drive spreads back to the wide end of the cycle (about 90 bps wider). Additionally, the prospect of the beginning of the end of global central bank support looms large across U.S., Europe and the rest of the world.

…Investment

Grade Corporate Credit Outlook: Technicals 2017 IG Gross Issuance to Approach 2016 Record

IG Maturity Wall Is Growing

Strong Inflows Continue to Support Technicals

June 28, 2017

Economics Group

Interest Rate Weekly Measure Twice, Cut Once— Identifying Aberrations Before any rush to judgment, a thoughtful approach includes identifying how a time series behaves and recognizing any aberrations that might suggest a mispricing of financial assets.