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BNP Paribas Market Call Summary - June 21, 2017

Core Content Overview

BNP Paribas provided a weekly cross-asset market view, highlighting the impact of rising US real yields and the potential for market disruption due to the Federal Reserve's planned balance sheet reduction. The analysis also covered asset mispricings, Sharpe ratios, and the implications of low volatility on carry trades and risk appetite.

Key Points

1. Fed Balance Sheet Reduction

• The Fed is expected to start reducing its USD 4.5tn balance sheet in July 2017.
• This reduction is likely to increase term premiums and affect asset prices more significantly than interest rate hikes.
• The balance sheet reduction plan includes:
  • Initial cap: USD 6bn/month for UST, USD 4bn/month for MBS.
  • Future increase: Caps will double each quarter, reaching USD 30bn/month for UST and USD 20bn/month for MBS.
  • Target size: Estimated to be around USD 3tn over three years.
  • Net UST supply: Expected to rise by USD 30bn in 2017, USD 241bn in 2018, USD 256bn in 2019, and USD 201bn in 2020.
  • MBS supply: Expected to increase by USD 20bn in 2017, USD 163bn in 2018, USD 213bn in 2019, and USD 187bn in 2020.
  • Term premium: Theoretical impact on 10y UST term premium could be an increase of 100bp over three years.

2. Rising US Real Yields

• US real yields are rising due to a sharp drop in inflation expectations, driven by soft economic data.
• This trend could disrupt carry trades, as higher real yields increase the cost of borrowing and reduce the attractiveness of low-yield assets.
• The 10y real yield is the most important macro factor, explaining about 55% of the total variance in the asset universe.

3. Asset Mispricings Identified by MarFA™

• Equities: MSCI World, MSCI Korea, and the Nikkei are overvalued by 2-4%, while MSCI South Africa is undervalued by 4%.
• FX: NZDUSD is overvalued by 3.5%, while USDCAD is undervalued by 2.4%.
• Rates: Several yield curves (US, Australia, Canada, Germany) are too flat, and French and Italian 10y yields are slightly too low.
• Commodities: Oil and gold appear slightly undervalued by 5% and 2%, respectively.

4. Volatility and Carry Trades

• Volatility levels (both realized and implied) have declined, supporting asset prices and increasing Sharpe ratios.
• Lower volatility has boosted the demand for carry trades, freeing additional capital.
• However, this has led to crowded positions in some risky assets.
• The VIX and MOVE index are at 20-year lows, indicating a low volatility environment.

5. Carry Trade Vulnerability

• Low volatility encourages higher positioning, but when volatility increases, the market may experience sharp corrections.
• The cycle reverses when volatility rises, and crowded trades may need to be unwound quickly.

6. Trade of the Week

• Recommended Trade: Short MSCI World, MSCI Korea, Nikkei, NZDUSD; Long USDCAD.
• Strategy: Buy 1y10y ATM + 25bp/75bp payer spread (1x-1).
• Entry: 12bp.
• Target: 50bp.
• Stop: 0bp.
• Carry: -1bp/month.

Main Asset Prognosis

Summary of Key Asset Correlations

• US 10y real yields are highly correlated with asset prices.
• Economic activity is the second most important macro factor, particularly for high beta assets.
• Commodity prices are less significant but still influence real yields and commodity-related FX pairs.

Risk and Investment Outlook

• Investors are not overly worried due to the availability of liquidity.
• However, the potential for higher long-dated bond yields could become a headwind sooner than expected.
• EM sovereign bonds have seen improved Sharpe ratios following the US elections, with orderly price increases.
• EM FX basket trades are supported by the combination of higher yields and low volatility.

Additional Information

• The MarFA™ framework is used to monitor asset prices and identify mispricings based on macro factors.
• The analysis suggests that the current low volatility environment may not last, and investors should prepare for potential volatility spikes.
• The document includes dial-in and replay numbers for the market call, which can be accessed with the password: 'The BNP Paribas Markets Call'.