Market View –

8/21/2019
 German Bonds: Little demand for German bonds, weak auction for most recent 30-year
with low bid-to-cover ratio, maybe stimulus down the road, possibly cheaper down the
road. Inflation is weak, a little bit in the U.S., surprising thing though is that with the
massive expansion of balance sheets and printing of money by the central banks, there
was no inflation at all, reflecting the massive balance sheet recession.
 Growth Side – Maybe people are too pessimistic. Fiscal space available, although many
monetary authorities are feeling restricted, with not much more they can do. If fiscal
and monetary authorities work together, more reason to be optimistic on growth.
 Events: ECB, what will they be doing in light of a slowdown in Europe? Will the fed care
to qualify what the market took as a rate cut in July. Will Powell follow it up in Jackson-
hole? Very divided FOMC will be a cast on the Jackson Hole meeting.
 Rates Positioning: Flagging near extremes. People are long because they are looking for
hedges, equities remain near all-time highs, and according to surveys, 10-year is used as
a hedge; not necessarily that they expect fed is going to come through on more cuts. 10-
year notes are providing hedge, protect against something going wrong down the line.
 At what point are yields so low that treasuries no longer provide hedge? We may be
quite a bit away from that… Bimodal distribution around what fed to do; mid-cycle
adjustment vs. fed having to revisit zero lower bound. In a place where it is hard to
interpret what market is saying right now, drawing a line between two extremes. Not a
lot of end demand for negative rates… Especially in Germany.
o Bund yields even lower to year-end. A few key differences to tease out relative
to 2015; poor 10-year auction in April that year. Economic surprises continue to
be negative, PMI much weaker levels, Economic risks much more clear and
present in 2015. Weakness in Chinese data yet to be reflected in European data.
FX hedge as well, with yields relative to treasuries.
o Change in the narrative would shift the Bund yields. Trade war ending, fiscal
policy impulse, something that most people would understand as fiscal impulse,
would put bunds in a different backdrop. Chinese infrastructure investment vs.
Chinese currency depreciation. Without these, no inflation expectations in
Europe, means bonds won’t’ sell off yet, yields will continue to go lower. German
Fiscal Stimulus: Balanced budget policy removed? Stave off a downturn that’s
really painful?
 Yield Curve: Should be a bull steepener when fed starts to cut, but that isn’t happening.
Right now, the curve is inverting.
o Why is it taking so long? Unusual for curve inverting after the easing cycle.
Market believes that the Fed is behind the curve. Not a normal rate cut cycle
then; it is an economy that was recovering somewhat above trend, but is being
tripped up by a global manufacturing cycle that slowed materially, facing
meaningful storm clouds on horizon, without a lot of evidence of weakness in
domestic economy so far.
 o Hedged demand is a yield curve that inverts after the beginning of the easing
cycle. Europe -> policy talk considerably more constrained, with central banks
running out of ammunition. Lower and flatter yield curve to be expected.
o People are piling their money into longer term debt because they are unsure of
the short-term prospects of the economy. They are also signaling to the market
that they are not afraid of inflation (which picks up in good times) eroding the
value of their discounted future cash flows of long-term fixed-income assets, as
they are willing to buy the longer tenors at lower and lower yields.
o Self-fulfilling expectations and the harm on financial intermediation from
negative spreads could lead to recession itself.
 But what about… Is the inversion due to the decline in the term premium
or decline in the average of the expected path of short term rates. Right
now, the inversion is actually due to the decline in term premium,
whereas in 2008 it was due to the expected path of short term rates.
8/22/2019
 Economy: Are we at a sort of equilibrium right now? Where do we put the neutral rate
right now? Judge policy to be accommodative with last rate cut, real rates are operating
close to 0 right now. Not tight for any sense. Was December rate increasing a mistake?
Then, we saw mounting downside risk, leading to concern about outlook. Last two
quarters, economy has grown, and has absorbed that risk.
o Markets are calling for a 50-basis point cut – judgements about how to read the
data up until the time of the meeting. Markets see how the rest of the world is
slowing, markets are sending signs of fear and uncertainty right now, but will
central banks focus on those metrics.
o Even if there is a deal, uncertain what deal would look like. Damage has already
been done, businesses has retrenched investment, factory activity has collapsed,
manufacturing has been hurt, trade war = businesses are losing clients; these
things are things that can’t be reversed. There must be re-orientation that would
benefit the global economy from trade to see a reversal.
o Services sector has been doing well, despite manufacturing downturn. Regionally
and domestically and globally there has been some bright spots, as consumers
are still spending. (Target and Lowe’s earnings, etc.)
 Minutes: Will there be as much discord and disagreement, and a confused set of
committee members? Should we be more patient on cutting rates? Are we buying long-
end of the treasury curve? Pretty bullish on long-end of the treasury curve, right now it
is at a 2.02% yield, and it looks like a cheap asset relative to other sovereign debt
globally, because the reach for yield will continue to push that down in the weeks
ahead.
 Central Bank Stimulus: Will they cut again once or twice this year, and once or twice
next year, low to mid 1% level. More stimulus to come in the economy, maybe a chance
to buy corporate credit?
 50 and 100-year bonds? Not a good idea? Might try to round out a yield curve gap now,
finding a 20 year, improve liquidity in 10 and 30 area. Governments have to pay up to do
 the 50 and 100 year bonds to get markets to buy into that, and from a taxpayer
standpoint, that may be too expensive. Trump wants to be the guy to issue that bond,
so there may be a possibility. 50-year shouldn’t trade at much higher of a yield, a little
more duration, but has a LOT more positive convexity; rates fall, lot of bang for buck.
Theoretically shouldn’t yield more, but should come cheap to a yield premium to the 30
year. Cheap way to get long duration in a portfolio. Bad for tax payers good for
investors.
 Negative Yielding Debt: Reach for yield is alive and well. Global bond investors are being
forced out of their domestic markets into positive yielding markets. One of the reason
why treasury curves and credit spreads have benefitted from the reach of yield. Major
demand for positive yielding securities. Fixed income market will continue to be
beneficiary of international flows.
 Curves are flat everywhere in the world, global bond market and a global phenomenon.
If it is steep enough, and enough rate hikes priced in to German curve, perhaps the
German bonds look good. But running money against major global bond indices,
negative yielding bonds don’t look attractive.

Fed Minutes:
 Move to cut interest rates last month as a recalibration rather than the start of a more
aggressive easing cycle. Don’t know how future moves will unfold. Uncertainty
surrounding trump’s trade policy wasn’t going to let up any time soon, making a
persistent headwind for U.S. economic outlook. Didn't spell out in much detail how to
lower rates in months ahead, but stressed need to be flexible.
o Reasoning include, manufacturing slowdown and a decrease in economic
investment and growth globally, an insurance cut in light of the growing trade
tensions between the Trump administration and China, and inflation running
below their 2% target and symmetric reasoning.
 Struggled to find a consensus reason because there were so many. Why would they
keep cutting rates absent obvious signs of economic deterioration? The Chairman’s
job in the following weeks will be to answer that question.
 Part of Powell’s perceived miscommunication and lack of clarity is traced to the multiple
reasons why the committee voted the way they did for the 25 bps cut.
Japan: Bullish, Why?
General Points
 Productivity growth outlook. Demographic challenges are a key economic headwind, but
recent productivity growth is already among the highest in the G7, despite an aging
population.
 Further improvements in productivity will come from population trend working
favorably in new era of AI, robots, and automation, and the normalization of
macroeconomic activity as deflation is overcome.
 Should reflect in a sustained positive nominal GDP growth reaching over 2.0% in 2021-
2025.
 Improved productivity and ROE turnaround. Deflation has ended, sustained gains in
private sector capex is being realized for the first time since the bubble, total factor and
labor productivity growth is at the top of the G7, MSCI Japan’s ROE is improved.

FX and Rates Space

 Japanese Yen – Undervalued. Real effective exchange rate depreciate over the past two
decades, due to deflationary and capital-exporting economy nature. Yen strengthens in
times of global risk aversion as it has developed safe-haven characteristics due to its
sizeable foreign asset holdings which require hedging when international asset volatility
is rising. Repatriation flows from foreign fixed-income assets will keep appreciation
pressure on JPY. Aging population suggests we may have seen the peak in savings
contributions from the working population -> Elderly population will convert from a
saver to consumer, requiring liquidation of asset holdings.
o Local savings in Japan have exceeded domestic investment opportunities and
recycling of current account surpluses call for purchases of long-term foreign
assets. Japan capital exports contribute to global liquidity conditions and push up
asset valuations and drive down global yields.
o Global bearishness and the sensitivity of the JPY to the US yield curve can imply a
stronger Yen relative to the dollar in the coming weeks and months.
o Japanese investors are also lifted risk preferences, pushing debt holdings into
higher-yielding assets. Liquidation of Japan’s foreign holdings would eventually
drive up foreign asset premiums, which could unleash a self-reinforcing cycle of
JPY strength.
o As domestic productivity increases, the opportunity cost for domestic investors
to go overseas increases, disincentives international investment and keeps yen in
Japan, appreciating the JPY.
o Higher productivity will push negative real yields gradually higher via investment.
Demand for non-JPY denominated assets decline, keeping JPY strong.
 Rates – don’t expect a sharp repricing of the term premium component even from a
long-term perspective, as investors will buy as real rates rise, despite BoJ normalization
of balance sheet.
o Higher productivity leads to higher real yields. Nominal long-term interest rates
to face upward pressure due to a rise in real interest rates. Productivity growth
 leads to boosts in expectation for future growth, driving up the real short-term
rates expectation, and hence nominal long-term rates, all else equal.
o Investor supply/demand trends, BoJ, and overseas developments matter to
market more.
o In Japan, the supply/demand factor explains the biggest chunk of movements in
the Yield curve, which is surprising to overseas investors.
o That said, fundamentals are not as big of a story in the Japanese yield curve.
Underlying inflation remains far from the BoJ’s 2% inflation target, and market
participants will not likely price in exit strategies in the near term, and have little
reason to think participatns will be interested in major economic factors.
o YoY observed rate of inflation, the 2% CPI, is still probably their biggest concern,
and will continue to expand the monetary base.