Please refer to important information at the end of the report. www.GlobalMarkets.bnpparibas.com New York London Brussels Hong Kong Tokyo 09:00 14:00 15:00 21:00 22:00 PASSWORD 'The BNP Paribas Markets Call' 18 OCT 2017 EVERY WEDNESDAY LIVE All the dial-in details are available at the back of this document ROBERT MCADIE Global Markets Head of Strategy Research
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Please refer to important information at the end of the report.
www.GlobalMarkets.bnpparibas.com
New York London Brussels Hong Kong Tokyo
09:00 14:00 15:00 21:00 22:00
PASSWORD 'The BNP Paribas Markets Call'
18 OCT
2017
EVERY WEDNESDAY LIVE
All the dial-in details are available at the back of this document
suggests local Phillips curves no longer capture the whole picture
All sources: BNP Paribas, Bloomberg, Macrobond
Chart 3: Emerging markets Phillips curves are also
flattening and with a declining R²
y = -0.999x + 10.632 R² = 0.207
y = -0.6211x + 7.0888 R² = 0.153
-8
-6
-4
-2
0
2
4
6
8
10
12
0 2 4 6 8 10 12
Nom
ina
l W
ag
e G
row
th y
/y %
Unemployment %
1990-2008
2008-2017
y = -0.6876x + 8.7306 R² = 0.3571
y = -0.3983x + 5.3039 R² = 0.123
y = -0.1348x + 2.9953 R² = 0.033
-4
-2
0
2
4
6
8
10
12
0 2 4 6 8 10 12 14
Nom
ina
l W
ag
e G
row
th y
/y %
Unemployment %
1990-2002
2002-2008
2008-2017
y = -3.7952x + 41.552 R² = 0.1881
y = -1.7181x + 19.925 R² = 0.2669
y = 0.215x + 5.1201 R² = 0.0011
-5
0
5
10
15
20
25
30
2 4 6 8 10 12
Nom
inal W
age G
row
th y
/y %
Unemployment %
1991-2002
2002-2008
2008-2017
y = -12.167x + 84.149 R² = 0.4214
y = -1.1989x + 11.568 R² = 0.6643
y = 0.7937x - 1.0118 R² = 0.0391
0
2
4
6
8
10
12
14
5 5.5 6 6.5 7
Inflation y
/y %
Unemployment %
1991-2002
2002-2008
2008-2016
Expected reduction in QE purchases should drive up yields, as support
for bonds weakens
6
Chart 1: UST and Bund yields have been driven by global QE,
especially ECB and BoJ QE
Chart 2: Global QE flows to decrease markedly
in 2018
Chart 4: Bund yields are also likely to rise in 2018 (Rsq = 74%)*
All sources: BNP Paribas, Bloomberg, Macrobond
Chart 3: US yields likely to rise in 2018 (Rsq = 59%)*
Global QE flows Global QE flows
US
10y y
ield
s
Bund y
ield
s
The pace of
buying drops
by
$48bn/mth
*Charts 3 and 4 do not show a pricing model, they show the relationship between two variables, so the r-squared is partly the function of missing variable bias
2,000
3,000
4,000
5,000
6,000
7,000
8,000
9,000
10,000
2009 2010 2011 2012 2013 2014 2015 2016 2017
FED balance sheet
ECB + BoJ balance sheets
Our expectations for QE reduction over the next few months
7
Chart 1: ECB and BoJ balance sheets increase with the Fed
stable, increasing gap between EUR & JPY, and USD
Chart 2: Global central banks balance sheet expansion has
pushed investors to look for alternative investments
Chart 4: EM flows remain strong, despite central bank
balance sheets increasing at a slower pace
All sources: BNP Paribas, Bloomberg, Macrobond
Chart 3: QE divergence is feeding through markets to
support a widening of US rates relative to Bunds
-1.0%
-0.5%
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
-
1,000
2,000
3,000
4,000
5,000
6,000
7,000
8,000
9,000
10,000
FED
ECB + BoJ
Tsy vs Bund sp
Going forward:
• Fed: B/S reduction starting at
USD 10bn/month and increasing to
USD 50bn over 12 months
• ECB: Pace of purchases to decline to from
January (*)
• BoJ: To be maintained at recently reduced
pace of JPY 60trn/year (from JPY 80trn)
Overall: Global
central bank balance
sheet to continue to
expand, but at a
markedly lower pace
ECB & BoJ have
been key drivers
of global QE
expansion
EC
B +
BoJ b
ala
nce s
heet
in B
usd
E
CB
+B
oJ b
ala
nce s
heet
in B
usd
0
10
20
30
40
50
60
0
100
200
300
400
500
600
2012Q4
2013Q2
2013Q4
2014Q2
2014Q4
2015Q2
2015Q4
2016Q2
2016Q4
2017Q2
bill
ion (
US
D)
bill
ion (
US
D)
Global QE Flows per quarter (lhs)
Cumulative EM Bond Flows (rhs)
EM flows expected
to slow as QE
begins to taper
Asset prices should correct as global QE unwinds. High yield bonds
have a strong beta, and equity valuations are currently very high
8
Chart 4: World equities are at risk given their beta and also
from their current high valuation*
Chart 2: EM bonds have been used as a carry trade and are
also vulnerable to the reduction of QE*
Chart 1: High yield bonds have a high beta to QE size and
are more at risk than other markets*
All sources: BNP Paribas, Bloomberg, Macrobond
Chart 3: US MBS markets have a smaller beta and should
react in line with US rates*
y = 0.209x + 91.13 R² = 0.6316
75
85
95
105
115
125
135
0 25 50 75 100 125 150 175 200 225
Price,
rebased 2
009=
100
)
billion
Last
y = 0.3821x + 97.496 R² = 0.5553
75
100
125
150
175
200
0 25 50 75 100 125 150 175 200 225
Price,
rebased 2
009=
100
billion
y = 0.4039x + 87.983 R² = 0.5985
60
80
100
120
140
160
180
0 25 50 75 100 125 150 175 200 225
Price,
rebased 2
009=
100
billion
Last
*These examples do not show a pricing model, they show the relationship between two variables, so the r-squared is partly the function of missing variable bias.
Last
y = 0.5307x + 85.434 R² = 0.6036
50
75
100
125
150
175
200
0 25 50 75 100 125 150 175 200 225
Price,
rebased 2
009=
100
billion
Last
Current market volatility premium is similar to 2004-2006, and we expect
volatility to be range bound and to slowly rise as QE is unwound
9
Chart 1: QE has suppressed volatility
Table 1: Economic and markets 2004-2006 vs 2015-2017
All sources: BNP Paribas, Bloomberg, Macrobond
Chart 2: Interest rate volatility as well as the ACM Term
premium is back to the 2004 to 2006 range
5.0%
15.0%
25.0%
35.0%
5,000
6,000
7,000
8,000
9,000
10,000
11,000
12,000
13,000
14,000
15,000
2009 2010 2011 2012 2013 2014 2015 2016 2017
Fed, ECB and BoJ balance sheet(in B usd, lhs)
VIX (in %rhs)
FE
D+
EC
B+
BoJ b
ala
nce s
heet
in B
usd
Comparison with 2004-2006: current equity PE ratios are much higher than during the
pre-crisis period. ERP is significantly higher today as current interest rates are low
10
Table 1: Equity – Z-score deviations from 15y average of
12m forward P/E ratio point to expensive valuations
All sources: Bloomberg, BNP Paribas
Chart 1: S&P 500 – 12m forward P/E has risen as investors
seek better returns than bonds
Table 2: Equity – Z-score deviation from 15y average of Equity
Risk Premium (ERP) – ERP currently attractive thanks to low rates Chart 2: ERP is below the past 15y average but still much
higher than in 2005, as rates were around 4.5% back then
Z-score deviation from 15yr average of 12m fwd P/E
Dec-04 Dec-06 Sep-17
SP500 0.70 0.37 1.81
SX5E 0.09 0.45 1.20
Nikkei -0.02 0.64 -0.28
FTSE100 0.50 0.16 1.23
MSCI EM -0.11 0.59 1.05
Equity valuations are
higher now than in
2004-2006, except
for Japan
Based on equity risk
premium, many
equity indices are
cheaper vs bonds
than in 2006
Z-score deviation from 15yr average Equity Risk Premium (earnings yield – govt bond yield)
Dec-04 Dec-06 Sep-17
SP500 -1.35 -1.52 -0.37
SX5E -0.78 -1.46 0.23
Nikkei -0.39 -1.23 0.78
FTSE100 -1.73 -1.41 0.15
MSCI EM -0.56 -1.03 -0.34
10.0
12.5
15.0
17.5
20.0S&P 500 P/E
15.39 average
0.0%
2.5%
5.0%
7.5%
S&P ERP
3.6% average
Bonds: valuations are very rich. As QE unwinds, growth continues to improve and
inflation eventually picks up we expect bond yields to rise, albeit not significantly
11
Chart 1: US 10y Treasury vs 17y average
All sources: Bloomberg, BNP Paribas
Chart 2: US 30y bond vs neutral rate (r*)
Table 1: Bond – Z-score deviation from 15y average
shows yields can rise significantly from current levels Chart 3: Germany 30y bond vs neutral rate (r*)
Z-score deviation from 15y average
Dec-04 Dec-06 Sep-17
US 10y 0.56 0.95 -1.09
German 10y 0.46 0.63 -1.62
EMBI, Spread -0.40 -1.34 -0.56
EM bond spread is
at similar levels to
2004. In 2006 it was
tighter
The neutral nominal
rate is based on
estimates of long-
term productivity
growth and inflation.
It tends to provide a
gauge for 30y bond
yields
The 10y risk-neutral
rate is the yield that
corresponds with
current growth and
inflation
Long duration combined
with low yield (30y Germany
is close to.1.25%), losses
from higher rates can be
steep
%
%
%
Credit: Spreads are wider than in 2004-2006, as there are few structured credit related
protection sellers. Financial CDS spreads are also much wider today
12
Table 1: CDS - Z-score deviation from 15y
average – CDS not as tight as 2004-2006
All sources: Bloomberg, BNP Paribas
Chart 1: Itraxx Main index is still wider than in 2005, with
financial CDS spreads still far from lows
Table 2: Cash OAS – Z-score deviation from 15y average
Cash spreads are also not as tight as 2004-2006
Chart 2: EM Global Bond Index spread is hovering
close to its seven-year moving average
Z-score deviation from 15y average (Spread)
CDS spreads are
slightly wider than in
2004-2006
Z-score deviation from 15y average (CDS/spread)
Dec-04 Dec-06 Sep-17
Itraxx Main -1.17 -1.48 -0.75
Itraxx X-over -0.83 -1.08 -1.00
CDX IG -0.34 -1.33 -0.72
Dec-04 Dec-06 Sep-17
EU IG -0.90 -0.83 -0.29
EU HY -0.90 -1.06 -0.92
US IG -0.93 -0.85 -0.59
US HY -1.11 -1.16 -0.77
EMBI -0.40 -1.34 -0.56
Cash are also
slightly less tight
than in 2004-2006
0
50
100
150
200
Main index (in bp)
87 bp average
Today, there are few
CDOs to provide
downward pressure
on CDS spreads In 2006, financial CDS index
was below 15bp
Spre
ad in
bp
G10 and EM FX: Versus our long-term fundamental exchange rate model the USD is
overvalued; GBP and JPY undervalued
13
Table 1: G10 FX – Z-score deviation from FEER
(Fundamental Equilibrium Exchange Rate)
All sources: Bloomberg, BNP Paribas
Z-score deviation from BNP Paribas FEER
Dec-04 Dec-06 Sep-17
US TWI -0.06 0.45 1.03
UK TWI 0.59 1.33 -0.57
JP TWI -0.62 -1.92 -2.39
EU TWI 0.35 0.30 0.02
EURUSD 0.29 0.22 -0.85
USDJPY 0.53 2.29 2.09
Chart 1: BNP Paribas FEER – EURUSD appears to
be undervalued over the medium term
Z-score deviation from 15yr average of REER
Real TWI Dec-04 Dec-06 Sep-17
BRL -0.79 0.36 -0.52
MXN 0.17 0.11 -1.12
TRY 1.17 1.18 -1.99
ZAR 0.80 -0.25 -0.36
RUB 0.47 1.41 -0.75
IDR -0.19 1.01 0.30
Table 2: EM – Z-score deviation from 15y average of
REER (real effective exchange rate)
Chart 2: TRY – Currencies deviate around the
average of their REER over the long term
The USD is currently
significantly
overvalued and the
JPY is undervalued
EM currencies
appear undervalued
on a real trade-
weighted basis
In 2006 most were
overvalued
0.65
0.85
1.05
1.25
1.45
1980 1985 1990 1995 2000 2005 2010 2015
BNP Paribas FEER EURUSD
OECD "Synthetic" EUR
prior to 1999
1.33
Real effective exchange rate
is a weighted average of a
country’s currency relative
to the currencies of its major
trading partners, adjusted for
inflation.
Trade of the week: Consider a 5y5y payer swaption to benefit from higher rates as QE
unwinds. Current entry point is favourable as volatility is cheap
We expect US rates and volatility to rise, and the curve to steepen
up to the 10-year point as the Fed starts to reduce the size of its
balance sheet.
Our revised forecasts imply that the largest US sell-off (versus forwards)
should occur on the 10y in 2018. We target a rise in the 10y yield to
2.75% by the end of 2018.
Buy 5y5y at the money forward payer (with a current strike of
2.55%). Entry level: 65bp with a target of 115bp and a stop at 50bp
(current: 67bp). Monthly carry is -0.9bp.
The rationale behind the trade
Global QE reduction: we expect the Federal Reserve’s balance sheet
normalisation and ECB QE tapering to push up rates and volatility.
Steepening exposure: Paying forward rates (5y5y) will also benefit from
a steeper curve. We expect the 2s10s curve to bear steepen versus the
forwards as we expect the change in the Fed’s SOMA reinvestment policy
(announced in September) to increase 10y UST term premium.
Carry efficiency: roll-down is similar to paying 5y5y swap; volatility carry
is minimal as the option is long dated. The trade should benefit from
higher volatility and a long gamma profile.
Timing and liquidity: the negative carry is more manageable on longer
expiries, allowing time for the trade to work. The 5y5y is a liquid point that
should reflects the direction of the volatility surface.
Chart 1: Non commercial futures positioning in the longer
end of the US bond futures remains close to flat
Chart 2: Interest rates and volatility at or near historical lows
Source: Macrobond, BNP Paribas, CFTC
14
Short futures positioning
Long futures positioning
3.2%
vol
Dial-in numbers
15
Replay numbers
16
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