Australia

Special Report

Highlights Dusting Off The BCA Bond Model: As central bankers moving away from the hyper-easy monetary policies of the post-crisis era, reverting back to more traditional bond investing tools, like our BCA Bond Model - which focuses on cyclical economic pressures, valuation and momentum - can be useful. GFIS Composite Bond Indicators: After adding a new element to our classic Bond Model, carry, we come up with a new measure to assess government bond markets - the GFIS Composite Bond Indicators. Current Signals: Our new indicators point to Australia, Canada and the U.K. as looking more attractive on a relative basis than Germany or France. Feature For global fixed income investors, four key questions matter most in selecting which government bond markets to prioritize at the country level: Where each country stands in its economic cycle? Which bonds offer the best value? Which bonds exhibit the strongest price momentum? Which bonds benefit from the best carry? To answer those questions, BCA has built specific macro indicators over the years. The ones related to the cycle, value and momentum form the building blocks of the BCA Bond Model. We have not spent as much time discussing these indicators in recent years. This is because the performance of bond markets has been dominated by extraordinarily easy monetary policies (quantitative easing, negative interest rates) in the major economies since the Great Recession. As more central banks start to question the need for maintaining those crisis-era policy settings, however, the utility of referring back to our classic bond indicators is growing. In this Special Report, we re-examine our bond indicators, explain briefly how they were built, evaluate quantitatively if they still provide a consistent signal and elaborate on the best way to utilize them. To enhance the existing model, we add a "carry" component to it, which is a vital part of bond investing. Since the cyclical, value, momentum and carry indicators often give different asset allocation signals at any given point in time, we propose a way to aggregate the information into one single indicator for each country, i.e. the BCA Global Fixed Income Strategy (GFIS) Bond Composite Indicators. We then test these indicators to see if they help bond portfolio managers outperform. The report concludes by comparing the latest message from the GFIS Bond Composite Indicators versus our current recommended portfolio positioning. Specifically, we explain why we are choosing to deviate from our indicators and assess how we could shift our tilts in the future. Evaluating The BCA Cyclical Bond Indicators The most important aspect of bond investing is to understand where each country stands in its current economic cycle. As a way to quickly assess this, we developed our Cyclical Bond Indicators many years ago. Tailored for each country, the Indicators are composed of economic data such as: the unemployment rate private sector credit growth the slope of the government bond yield curve commodity prices denominated in local currency terms realized inflation rates Since economies do not always exhibit the same sensitivity to common macro drivers, we created country-specific Cyclical Bond Indicators that each use a different set of variables. After transforming the data, using de-trending and standardizing techniques, the variables are aggregated to form a single indicator for each country.1 Although Developed Market (DM) countries typically appear to be in the same phase of their economic cycle simultaneously, there are always some slight differences between them. These are crucial to identify and can make a huge difference in the government bond asset allocation process. First and foremost, knowing where a country is in its business cycle should impact expected returns on fixed income. Theoretically, bonds should underperform as the economic cycle becomes more advanced and outperform as the economic cycle deteriorates. Statistical Observations To verify that last statement, we separated the cycle for each country in our DM bond universe into seven distinct phases for the economic cycle: Euphoria End of upturn Upturn Downturn End of downturn Crisis Mega Crisis The phases of the cycle are defined by how much the Cyclical Bond Indicator diverges from its mean, which is always zero since the Indicators are standardized (i.e. removing the mean and dividing by the standard deviation). Chart 1 illustrates how our four core countries (U.S., Germany, Japan, U.K.) have gone through those cycles since 1967. At the positive end of the spectrum, the Euphoria state represents instances where economic variables have been especially upbeat (i.e. the Cyclical Bond Indicator is more than two standard deviations above the mean). At the negative end, the Crisis and Mega Crisis periods are when the Cyclical Bond Indicator is more than two and three standard deviations below the mean, respectively. Chart 1The BCA Cyclical Bond Indicators For The 'Core Four' Markets To evaluate the usefulness of the Cyclical Bond Indicator as an investment tool, we have calculated the average monthly return during each phase of the cycle for the major DM countries with a one-month lag (i.e. the March 2017 returns are based on the signals given by the February 2017 readings of the Indicators - this is done throughout the rest of this report when testing other bond indicators). The results are shown in Table 1. Table 1Bond Market Performance, Seen Through Our Cyclical Bond Indicator As expected, the average monthly performance tends to increase as an economy enters a downturn. Conversely, as an economic upturn gathers momentum, the performance of the bond market tends to decline.2 In Table 1, we highlighted the current phase for each country. Australia and U.K. are the only countries in Downturn territory right now; compared to their peers, those two countries would have the largest expected return3 of this group. On the other hand, the U.S. economy might be at the End of Upturn phase, when Treasuries should be expected to post the worst return, if history is any guide. In Table 2, we broke out the monthly results into 10-year periods to test the consistency of the indicator performance over time. Unsurprisingly, the End of Upturn phase has been quite detrimental for the DM bond markets during all eras, while the End of Downturn episodes have been good for bond investors in every decade. Table 2Bond Market Returns During ##br##The Various Stages Of Our Cyclical Bond Indicator Are Consistent Across Time Chart 2The Gains From Bond Investing##br## According To The Economic Cycle Finally, we looked into the usefulness of the Cyclical Bond Indicators in helping construct simple bond portfolios by using them as a ranking tool using the steps described in Box 1. The big picture takeaway is this: the countries with the three highest ranking Cyclical Bond Indicators (i.e. those with the slowest economic growth) outperform by roughly +6 basis points (bps) per month, on average. Similarly, the countries with the lowest-ranked cyclical indicators would underperform by -6bps, on average (Chart 2). Box 1 Ranking Bond Returns Using The BCA Cyclical Bond Indicators We calculated the average monthly excess return by buckets using the following steps: We ranked the ten countries in our bond universe by the level of their Cyclical Bond Indicators, from lowest (ranked #1) to highest (ranked #10). We then calculated the monthly currency-hedged excess return of each country versus the average of all the countries in our DM bond universe We then aggregated all the monthly results to have an average excess return for all ten of our ranking buckets We then separated them further into three buckets (the top three, middle four and bottom three ranks) and averaged the monthly excess returns for those groupings. Comments There is nothing particularly out of the ordinary with those findings - the countries with the weakest economies have the best performing government bond markets. However, the results of these statistical exercises confirm that the BCA Cyclical Bond Indicators are reliable and can confidently be used to support our qualitative analysis for each country. Importantly, following those indicators brings a dose of discipline to our bond allocation framework. For example, if our initial qualitative macro analysis diverges markedly from what the Cyclical Bond Indicator is telling us, this would represent a red flag that prompts us to question our initial conclusions. We will highlight situations like this later in this report. Evaluating The BCA Bond Value Indicators To assess the richness or cheapness of DM government bonds, BCA developed a Bond Value Indicator for each country. It is composed of several measures that have a fundamental macroeconomic relationship to bond yields, such as: Central bank policy rate expectations Trend inflation The deviation of the exchange rate from Purchasing Power Parity (PPP) The 10-year U.S. Treasury yield (as a proxy for the global bond yield) The variables are transformed using regressions, then combined to form a single measure of how far bond yields are from a theoretical fair value. Similar to other components of the BCA Bond Model, the power of these country indicators arises when comparing them amongst each other. Bond markets with yields below fair value should outperform those with yields above fair value. Just like all other asset classes, valuation is a poor tactical timing tool for fixed income. Our Bond Value Indicator is more useful in the long term; value can remain cheap/expensive for an extended period of time. For example, Germany has been the most, or second-most, expensive bond market in our bond universe since June 2013. Due to this shortcoming, the Bond Value Indicator will be given a smaller weighting in our composite indicator laid out later in this report. Statistical Observations To test this indicator, we looked at the hedged excess monthly returns generated using the same ranking procedure laid out in Box 1. The results show that investors can expect to earn about +12bps per month in excess hedged return from countries with the three cheapest valuations according to the Bond Value Indicators, and can expect to lose -6bps/month in countries that are ranked most expensive (Chart 3). Moreover, betting on countries with the cheapest ranked valuations skews favorably the odds of outperforming, from about 46% to 53% (Chart 4). Chart 3The Gains From Bond Investing ##br##According To Value Chart 4Favor The Cheaper Bond Markets Comments Currently, the U.S. bond market offers the best value (Chart 5). This contrasts unfavorably with our recommended underweight exposure to U.S. Treasuries. Nonetheless, we remain comfortable with this exposure since the U.S. economy is currently in the strongest economic cycle, and its bond market is technically less oversold than its peers (see the next section). Chart 5Bunds Look Rich, Treasuries Look A Bit Cheap Also, note that German and Japanese yields look quite expensive, although this is no surprise given the extremely easy monetary policy settings (negative rates, central bank asset purchases) in place from the European Central Bank (ECB) and Bank of Japan (BoJ). As we have discussed in recent Weekly Reports, we see far greater risks for the ECB moving to a less accommodative monetary bias in the months ahead than the BoJ, and we shifted our country allocations to reflect that view (moving to overweight Japan and cutting Germany to neutral).4 In other words, Japanese bonds will likely stay expensive for longer, unlike German debt. As we mentioned earlier, the value component warrants lesser importance in our tactical and strategic bond allocation framework since it is more long term in nature. In a nutshell, value is something good to have on your side when the macro backdrop shifts, but is not absolutely crucial to generate returns on a month-to-month basis. Evaluating The BCA Bond Momentum Indicator So far, the BCA Bond Cyclical Indicator informed us where the macroeconomic forces were the strongest and the BCA Bond Value Indicator helped us find bargains. This is all great, but bond investors could still underperform if their timing is off. The BCA Bond Momentum Indicator helps in finding the appropriate short-term timing. It has been built simply by looking at how far bond yields are relative to their primary medium-term trend. In theory, bond markets where yields are too stretched to the upside (oversold) should outperform versus countries where yields are too stretched to the downside (overbought). Statistical Observations Using the same ranking methodology explained in Box 1, investors can expect to earn roughly +11bps/month in excess return versus DM peers where conditions are the most oversold and should expect to lose -6bps/month from bond markets with the most overbought conditions (Chart 6). Comments While we do consider technical analysis as part of the tactical component in our bond allocation framework, we put less emphasis on it relative to other more fundamental factors that sustainably drive bond returns over time. Nonetheless, our ranked findings show that choosing markets based on price/yield momentum does generate fairly reliable outperformance. What About Carry? As seen so far, our traditional bond indicators encompass typical variables that would be expected to influence bond returns. Our framework would be incomplete, however, without incorporating the notion of "carry" - the investment return generated by the interest income on bonds. Having instruments that earn too little carry can be very harmful to the returns of a bond portfolio over prolonged periods. A simple observation of the long-term performance of higher-yielding credit markets (i.e. corporate debt or Emerging Market sovereigns) proves that point (Chart 7), especially in the current era where investors continue to stretch for yield given puny risk-free interest rates in so many countries. Chart 6The Gains From Bond Investing ##br##According To Momentum Chart 7Carry Plays A Huge Role ##br##For Long-Run Bond Returns Of course, most of the major carry gaps between DM sovereign bond yields disappear after currency hedging. However, even on a hedged basis, the carry differentials remain important. Currently, Italian debt carries the highest hedged yield in our DM bond universe, at 3.95%, versus 1.54% for Japan. The 241bp differential between the two is significant, especially in the current global low yield environment. However, some of that additional yield is compensation for the greater riskiness of Italian debt, given the many structural problems in that country (high debt levels, low productivity, political instability, fragile banks). In other words, a better way to evaluate carry is on a risk-adjusted basis. In Chart 8, we show the hedged 10-year government bond yields of the ten DM countries shown throughout this report, both in absolute terms (top panel) and adjusted for volatility (bottom panel). Note that Italy's ranking moves down two notches after accounting for the greater return volatility of Italian debt, while Spain offers the most attractive yield on a risk-adjusted basis. At the other end of the spectrum, Australia and Canada have less attractive yields relative to their volatilities than Japan - home of the 0% bond yield. Of course, as the old investment saying goes, "you can't eat risk-adjusted returns." As a general rule, bond markets with higher yields should be expected to outperform markets with lower yields over time. Statistical Observations An historical analysis of our DM universe using the methodology laid out in Box 1 confirms that observation. The bond markets with better ranked carry have a tendency to generate positive excess returns (on a currency-hedged basis) and, on average, produce more winning months than losing ones (Chart 9). This is true even though the higher-yielding markets are often those with higher inflation, or greater government debt levels, or more active central banks that create interest rate volatility. Chart 8Peripheral European Carry##br## Is Still The Most Attractive Chart 9The Gains From Bond Investing##br## According To Carry Comments Currently, the carry factor would favor overweighting Italy, Spain and France, while underweighting Japan, Australia and the U.K. Those relative rankings still generally hold up even after adjusting for volatility. Pulling It All Together: Introducing The GFIS Bond Composite Indicators Now that we have outlined the four elements of our proposed composite bond indicator, the question becomes: how do we aggregate those pieces? The components of our original BCA Bond Model rarely give the same message simultaneously, even after adding a new factor (carry) to the mix. Moreover, as discussed above, some elements (Cyclical and Carry) are more important than others (Value and Momentum) in delivering consistent outperformance of bond returns. Hence, to build a new composite indicator, we need to make a judgment call as to which component should be given more weight. Cyclical (50%). Here at BCA, we spend a fair amount of time trying to deeply understand economic cycles, which are a major driver of financial markets. Bonds are no exception, with changes in growth and inflation expectations forming the fundamental building blocks of yields. As such, we allocate a substantial 50% weight to the cyclical component of our GFIS Bond Composite Indicators. Value (15%). Value moves much more slowly than the other indicators and yields often diverge from fair value for long periods of time. As such, we are giving a smaller weighting of 15% to the value piece of the GFIS Bond Composite Indicators that we are designing to provide a timely signal for country allocation. Momentum (15%). Although technical analysis should be a meaningful part of any investment process, markets can often trend for extended periods before any consolidation, or even reversal, takes place. To reflect that, our momentum indicator will also carry only a 15% weighting in our composite indicator, the same as the weight given to value. Carry (20%). Carry should play an important part in a bond allocation framework. To use a sporting analogy - favoring higher-yielding bonds means starting the game with the score already in your favor. For that reason, we will give carry a 20% weight in our overall bond indicators. After combining our individual bond indicator rankings (from 1 to 10) using the weightings described above, we come up with an overall score for each country which becomes the GFIS Composite Bond Indicator (Table 3). Ranking the countries according to their respective scores gives a new indication as to which bond markets we might want to overweight or underweight. Table 3Combining The BCA Bond Indicators Statistical Observations Chart 10Our Composite Bond Indicator ##br##Adds Value At The Extremes To test the investment performance of our new GFIS Composite Bond Indicators, we created an equally-weighted index using the monthly hedged returns of the ten countries in our DM bond universe. We then created two portfolios: One composed of the countries with the three best composite scores; The other composed of the countries with the three worst composite scores. In both cases, those sample portfolios out-/under-performed the equally-weighted index as expected, proving that value can be extracted by following the recommendations of the GFIS Composite Indicators (Chart 10). Comments This automatic/quantitative ranking of the countries is designed as a guideline only. The goal here is to quickly find what could be the most appealing bond markets on a relative basis. Judgment on whether to apply the findings should and will always take precedence when we make our investment recommendations. Also note, in attributing weightings across the components, we have not used any optimization techniques to find the perfect balance. We simply relied on our judgment for a simple reason: optimization gives the best fit according to a set of historical market volatilities and correlations. During periods when volatilities change, or correlations become less stable, the historically-optimal weightings may produce sub-optimal investment results. We prefer to use a constant set of weights across our individual indicators, derived from our own investment intuition and preferences. What Could Be Our Next Portfolio Tweaks? We compare the latest rankings from our GFIS Composite Bond Indicators to our current fixed income country allocations in Table 4. Deviations between the two can provide some ideas for possible changes to our recommendations. Table 4The GFIS Composite Bond Indicator##br## Vs. Our Current Recommendations From this table, two observations arise: The three countries that rank the highest, Australia, Canada and U.K. are at neutral in our recommended portfolio (Chart 11). Should we move them to overweight? Among the three countries that rank the worst, we are still only at neutral Germany and France (Chart 12). Should we move to an underweight stance given the signal from our new Composite Bond Indicator? On the first point, we have turned decidedly less negative on Australia and U.K. bonds of late.5 In the next few months, if more signs of cyclical deterioration emerge, we will be tempted to align ourselves with our composite indicators and overweight those markets. Although as we discussed in a recent Special Report, another set of our in-house indicators, the Central Bank Monitors, are pointing to pressures to tighten monetary policy in Australia, Canada and the U.K., perhaps providing some justification for only being neutral on those markets.6 On the second point, we recently downgraded core Europe to neutral from overweight, given our growing concern that the ECB will be forced to announce a tapering of its asset purchases, likely starting in early 2018.7 We anticipate that our next move will be to a full-blown underweight position on both Germany and France, although we prefer to wait until after the upcoming French elections before making that shift. Given our view that the populist Marine Le Pen will not win the presidency, we expect to be cutting Germany before France, as there is still a wide political uncertainty premium built into French-German bond spreads.8 Chart 11Bond Upgrade Candidates Chart 12Bond Downgrade Candidates Going forward, we will continue to monitor our GFIS's Composite Bond Indicators to supplement/confirm our macro analyses and to discover some potential portfolio moves/trades. Additionally, we will look to further test and refine the Composite Bond Indicators by looking at different weighting schemes among the component indicators, how the correlations between the components shift over time (and if there is any information from those changes), and other considerations. Now that we've "dusted off" our classic bond indicators, there is plenty of additional research that can be done to build on the initial results shown in this report. Jean-Laurent Gagnon, Editor/Strategist jeang@bcaresearch.com Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 We have built the Cyclical Bond Indicators using data going back to 1967 for most DM countries, allowing for a robust historical analysis across the different bond markets. 2 Since global bonds have experienced a powerful secular bull market over the past 35 years, the majority of monthly returns in the history of the Cyclical Bond Indicator have been positive. As such, shorting bonds in absolute terms has seldom proved to be a value-added proposition. The only exceptions are when the macro landscape has entered the Euphoria state, which has been quite rare. 3 In local currency terms 4 Please see BCA Global Fixed Income Strategy Weekly Report, "Staying Behind The Curve, For Now", dated March 21, 2017, available at gfis.bcaresearch.com 5 Please see BCA Global Fixed Income Strategy Weekly Reports, "Will The Hawks Walk The Talk?", dated March 7, 2017 (on the U.K.), and "It's Real Growth, Not Fake News", dated February 21, 2017 (on Australia), both available at gfis.bcaresearch.com 6 Please see BCA Global Fixed Income Strategy Special Report, "BCA Central Bank Monitor Chartbook", dated March 28, 2017, available at gfis.bcaresearch.com 7 Please see BCA Global Fixed Income Strategy Weekly Report, "March Madness", dated March 14, 2017, available at gfis.bcaresearch.com 8 Please see BCA Global Fixed Income Strategy Special Report "Our Views On French Government Bonds", dated February 7, 2017, available at gfis.bcaresearch.com

Highlights The locomotive of the U.S. economy, the consumer, remains supported by powerful tailwinds. The Fed will be able to tighten monetary policy relative to other central banks by a higher degree than the market appreciates. The dollar will rise further. Use this dip to buy more dollars. Being tactically long the yen is a hedge against growth disappointments. Set a stop-sell for AUD/NZD. Feature In June of last year, we wrote a piece titled "What Could Go Right?" arguing key changes in the global economy may have justified a more pro-risk stance for investors.1 The core of the argument was that markets were pricing in a lot of negatives, as the annual return of the global stock-to-bond ratio was deeply negative and could only fall further if a recession were to emerge. Moreover, as commodity prices were improving, we foresaw a waning of deflationary forces that had engulfed the world. This easing deflation would cause real rates to fall and economic activity in EM to rebound. Chart I-1Global Asset Prices: From Gloom To Glee Over the subsequent nine months, this scenario moved from the world of theories to being the reality for the global economy. Today, the annual return of the global stock-to-bond ratio is now the mirror image of last June (Chart I-1). Thus, for the stock-to-bond ratio to move higher, we need to explore where growth may come from. Moreover, we need to consider whether this growth is likely to help the dollar or help other currencies. The U.S. Is In Charge The U.S. economy continues to show the most promise. It is true that some signs do point to a weak Q1. Much noise has been made about the decline in commercial and industrial loans. We are more sanguine. To begin with, the Conference Board includes C&I loans in its list of lagging indicators, not leading ones. Additionally, C&I loans lag banks' lending standards, and, in fact, the weakness in this subsection of credit aggregates is the natural consequence of the 2015-2016 tightening in lending standards. Their recent easing points toward a rebound in C&I loans, as do core durable goods new orders (Chart I-2). What is more concerning is the slowdown in credit to households (Chart I-3). The U.S. economy is driven by household dynamics and the Conference Board does include consumer credit in its list of leading indicators. Moreover, the amount of MBS and ABS on primary dealers' balance sheets remains in a downtrend. This is worrisome because it suggests that the slowing accumulation of consumer debt on banks' balance sheet is genuine, and not a reflection of securitization (Chart I-4). Chart I-2C&I Loans##br## Will Pick Up Chart I-3However, Household Credit ##br##Dynamics Are A Worry Chart I-4Securitization Unlikely ##br##To Be The Culprit However, there are causes to minimize these concerns. Mainly, the drivers of household income and spending are still healthy. First, U.S. financial conditions remain easy, a phenomenon that tends to boost GDP growth in the following quarters, suggesting that national income will remain strong. Second, the outlook for employment in the U.S. remains robust. As Chart I-5 illustrates, the employment components of the ISM and the Philly Fed surveys both point to a pick-up in job creation. This further supports the notion that nominal household income will strengthen Third, our real disposable income indicator, based on various components of the NFIB survey, is showing that households should enjoy strong income growth in the coming months (Chart I-6). Moreover, despite the failure of the AHCA, Marko Papic, the head of BCA's Geopolitical Strategy service argues that it will be much easier for the GOP to implement tax cuts, especially geared toward the middle class, than it was to repudiate the much-maligned Obamacare.2 This could further help household disposable income. Chart I-5Job Growth Will Rebound Chart I-6Household Income: Highway Star Fourth, household liquid assets represent 270% of disposable income, the highest level in decades. Moreover, household debt-servicing costs are still near multi-generational lows, suggesting that households are in the best financial shape they have been in decades. And fifth, household confidence has surged to its highest levels since 2000, reflecting both the large increase in net worth created by surging asset values as well as the very low level of unemployment in the U.S. (Chart I-7). Thus, the decline in the savings rate from 6.2% in 2015 to 5.5% at present could deepen further, adding more impetus to transform income gains into consumption gains. At the worst, this development suggests that the household savings rate will not rise much. These factors all imply that household consumption will remain robust and may in fact accelerate in the coming quarters. Consequently, that capex too has upside. We have highlighted how capex intentions have risen substantially, and this has historically been a powerful leading indicator of capex itself.3 However, the financial press is replete with commentators reminding us that the positive global economic surprises have mostly been a reflection of "soft data" and that "hard data" has not followed through. Not only do we philosophically disagree with this statement - historically soft data does indeed lead hard data - but as Chart I-8 illustrates, core capital goods orders have risen quite sharply, mimicking the developments in retail sales. A combination of strong retail sales and strong orders tend to portend to a rise in capex. Chart I-7Happy Shiny People Chart I-8Capex Will Rebound These developments raise the likelihood that U.S. growth will power the global economy and that the Fed will be in a good position to make good on its intent to increase interest rates two more times this year. In fact, there is even a growing probability that the Fed will add another tool to its tightening arsenal: letting MBS run off, resulting in a contraction of its balance sheet. The combined tightening of two more hikes and a shrinking balance sheet will be much greater than any tightening emanating from an ECB taper. As we argued last week: Europe's inflation and wage backdrop remains icy cold, limiting how far the ECB can tighten monetary policy.4 While an environment of globally rising rates is normally negative for the yen, with the BoJ displaying and even easier bias than in the past, any increase in rates in the U.S. is likely to supercharge weaknesses in the yen, as the BoJ will put a lead on JGB yields and force them to remain subdued.5 As a result of these views, we remain very committed dollar bulls on a 12-18 months basis and recommend using the current dip in the dollar as a buying opportunity, especially on a trade-weighted basis. Bottom Line: While consumer loan growth has slowed - which could result in a poor Q1 U.S. growth number - the outlook for U.S. household income and consumption remains promising. This will also feed through to higher investment growth, clearing the Fed's path toward higher rates. This dip in the dollar should be used as an occasion to buy the greenback. But Why Still Long The Yen Tactically? This position has two purposes. First, we have been worried about dynamics in China that could cause a correction in EM markets.6 More recently, the decline in Chinese house-price appreciation has deepened, representing an ominous sign for the iron ore market (Chart I-9). Poor metal prices tend to represent a negative terms of trade shock and therefore an economic handicap for many large EM nations. Moreover, back in June, the improvement in Taiwanese IP was one of the factors that prompted us to highlight a potential improvement in the global economy. So was the uptrend in our boom/bust indicator. Today, not only is the boom/bust indicator losing steam, but Taiwanese IP has sharply rolled over (Chart I-10). While this is not a reason to worry about our bullish view on the U.S. economy, this could suggest that the global manufacturing upswing has seen its heyday, a development that is likely to weigh more heavily on EM economies than on the U.S. Any EM stress is likely to boost the yen's appeal, temporarily countering the BoJ's aggressive stance. Chart I-9Problems For Iron Ore Chart I-10Two Clouds For Global Growth Second, we do not want to be dogmatic on our U.S. growth view. As the top panel of Chart I-11 illustrates, increases in 2-year Treasury yields have tended to lead to decreases in U.S. inflation expectations. While we would argue that the U.S. economy is on a stronger footing to withstand higher rates than at any point since 2010, a policy mistake is not out of the scope of probabilities. If rising rates is indeed a policy mistake, a large risk-off event would be a very likely outcome, one that boosts the yen. Finally, as the middle and bottom panels of Chart I-11 shows, a fall in U.S. inflation expectations would also extract its toll on EM and cyclical plays, further reinforcing any disappointment out of China, and further adding shine to the yen. Our original target on USD/JPY was 110, we are moving it to 108. At this point, we will become sellers of the yen, unless we see signs that the global economy is entering a more dangerous path than originally anticipated. Additionally, investors looking to express a bearish view on EM may want to go short MXN/JPY (Chart I-12). The peso has massively rallied and is now at a crucial technical spot against the JPY. Moreover, while being short USD/JPY may be a dangerous move - after all, we are playing what amounts in our view to a countertrend bounce in the yen - if EM are at risk, these risks could be exacerbated by the tightening in financial conditions created by a higher dollar. Mexico, with its high external debt, representing nearly 70% of GDP, is particularly exposed to this problem. Also, MXN, with its high liquidity for an EM currency, is often a vehicle for investors to play EM weaknesses. Thus, shorting MXN/JPY could be a great hedge for investors with long EM exposures. Chart I-11Are We Out Of The Woods Yet? Chart I-12A Gauge And A Play Bottom Line: Being tactically long the yen in a portfolio offers two advantages. First, it is a direct play on any disappointment of investors in the EM space, and, second, it is also a hedge against the risks to our strong U.S. growth view. AUD/NZD: Not A Bargain It is often argued that AUD/NZD is a bargain as it trade 6% below its purchasing power parity rate. This may be a valid reason to buy this cross, but only for investors with extremely long investment horizons, as PPP deviations can take seven years to correct. In fact, following the recent rebound in AUD/NZD, we would be inclined to short this pair once again. On the international front, AUD/USD seems to be driven by the dynamic in Chinese nominal GDP growth. We doubt Chinese nominal GDP growth will accelerate much beyond Q1. As Chart I-13 illustrates, AUD/USD seems to have moved ahead of Chinese GDP, putting this currency at risk. We also can also interpret AUD/NZD as a vehicle to play the growth rebalancing in China. The AUD (iron ore, other metals, and coal) is a bet on industrial and investment growth while the NZD (dairy, meat, and wool) is a wager on the Chinese households. As China moves away from an investment-led growth model toward a more consumption-led growth model, AUD/NZD should underperform. A simple fair value model for this cross designed to capture these dynamics as well as the USD dynamics indicates that AUD/NZD is 8% overvalued (Chart I-14). Chart I-13AUD Prices In Chinese Optimism Chart I-14AUD/NZD Is Expensive Moreover, still with an eye firmly planted on China, AUD/NZD has tended to perform poorly when Chinese monetary conditions tighten. The recent upward move in the Chinese 7-day repo rate could be a harbinger of bad things to come for this cross. Relative domestic factors also temper any bullishness on AUD/NZD. Kiwi house prices are outperforming Aussie prices and New Zealand inflation is catching up to that of Australia's. Moreover, the RBA has been paying more attention to the poor state of the Australian labor market, while that of New Zealand remains very strong. These dynamics suggest that kiwi rates could rise relative to that of Australia (Chart I-15). More technically, investors are massively long the AUD relative to the NZD (Chart I-16). This usually is a good signal to bet against this pair. Chart I-15Domestic Conditions Favor##br## Higher NZ Rates Vs. Australia Chart I-16Speculators ##br##Are Bullish Bottom Line: Shorting AUD/NZD at current levels makes sense. Not only is it a way to take advantage of the desire by Chinese authorities to rebalance growth away from the Chinese industrial sector, the Kiwi economy is outperforming that of Australia, and too much negativity has been priced in for the RBNZ relative to the RBA. Finally investors are overly long the AUD relative to the NZD. Set up a stop-sell of AUD/NZD at 1.1100, with a target of 1.000 and a stop at 1.1330. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, "What Could Go Right?", dated June 24, 2016 available at fes.bcaresearch.com 2 Please see Geopolitical Strategy Weekly Report, "Five Questions On Europe", dated March 22, 2017 available at gps.bcaresearch.com 3 Please see Foreign Exchange Strategy Special Report, "Outlook: 2017's Greatest Hits", dated December 16, 2016 available at fes.bcaresearch.com 4 Please see Foreign Exchange Strategy Weekly Report, "Healthcare Or Not, Risks Remain", dated March 24, 2017 available at fes.bcaresearch.com 5 Please see Foreign Exchange Strategy Weekly Report, "JPY: Climbing To The Springboard Before The Dive", dated February 24, 2017 available at fes.bcaresearch.com 6 Please see Foreign Exchange Strategy Weekly Report, "Healthcare Or Not, Risks Remain", dated March 24, 2017 available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The DXY displayed resilience this week: the third estimate for U.S. GDP in 2016Q4 outperformed expectations at 2.1%, after being revised up from 1.9%; consumer confidence increased to 125.6, the highest level since 2000; yet Initial jobless claims ticked in at 258,000, underperforming expectations of 248,000 but beating previous figures of 261,000. Another factor lifting the dollar were recent comments by Secretary of Transportation, Elaine Chao, who stated that Trump's $1 trillion infrastructure plan will be unveiled later this year. This could be considerably positive for U.S. economic growth as it will cover a large part of the economy: "transportation infrastructure, energy, water and potentially broadband and veterans hospitals as well." Although specifics were not disclosed, such stimulus in the face of tightening labor market could fan inflation. Under the assumption of a proactive Fed, this could translate into a strong dollar. Report Links: USD, Oil Divergences Will Continue As Storage Draws - March 17, 2017 Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Last week's hawkish comments by ECB board member Ewald Nowotny drove the euro higher, while recent comments by Peter Praet confirmed that "a very substantial degree of monetary accommodation is still needed", which pushed the euro down. Promoting the euro's downside were Italian industrial sales and orders, which contracted at a monthly pace of 3.5% and 2.9% respectively, although annual rates remain positive. Article 50's invocation was another factor which contributed to volatility. How Brexit negotiations evolve will dictate movements in EUR/GBP for the foreseeable future. President Tusk's demeanor was also quite negative in his speech, focusing on minimizing "the costs for EU citizens, businesses and Member States". In other news, Portugal's Finance Minister Mario Centeno hinted at a possible upgrade to the growth forecast to around 2% from 1.5% as exports grew by 19% in January. As exports continue to be a key driver of growth for this country, this suggests a weaker euro is still needed to support growth in the periphery. Report Links: Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 The French Revolution - February 3, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data has been mixed for Japan: Corporate services prices rose by 0.8% year-over-year, outperforming expectations. However, retail trade yearly growth deteriorated to 0.1% from 1% the previous month, underperforming expectations. Furthermore, manufacturing PMI fell to 52.6 from 53.3 the previous month. We are changing our tactical target for USD/JPY from 110 to 108. The decline in Chinese property prices as well as slowing inflation expectations in the U.S. might create a risk off environment that will affect carry currencies and will benefit the safe havens like the yen. On a cyclical basis, we remain yen bears, as recent sluggishness will only embolden BoJ policy makers to maintain their radical monetary stance. Report Links: Et Tu, Janet? - March 3, 2017 JPY: Climbing To The Springboard Before The Dive - February 24, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 It's official: Theresa May has triggered Article 50. The pound reacted relatively positive to the event as both parties in the negotiations chose to start with the carrot rather than the stick: In her letter to the EU Theresa May stated that she hoped to enjoy a "deep and special" relationship with the European Union once Brexit is finalized. On the other side of the channel, Donald Tusk also pledged to work "closely" with their counterparts in London, and that he hoped that the U.K. will stay a close partner after Brexit. These developments are encouraging, as it shows that cooler heads might prevail at the end of the day. This rosier outlook in an environment where expectations for the Britain are still too pessimistic makes the pound a very attractive buy, particularly against the euro, despite the potential for short-term volatility as the stick will ineluctably come out. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017’s Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 In an attempt to curb housing market euphoria, all four major banks - ANZ, CBA, NAB and Westpac - increased lending rates on investor and interest-only mortgages this month. Fitch Ratings reports that the tightening was done "ahead of probable regulatory tightening", as hinted frequently by the RBA. Rising wholesale funding costs due to tighter U.S. policy is also a motivating factor behind this. For the time being, the housing market risk will continue to be restricted through macroprudential policies rather than actual tightening by the central bank. Eventually risks related to record-high household debt will limit the capacity of the RBA to increase rates. On the brighter side, banks are well positioned with strong capital buffers and pre-impairment to profitability, with Fitch rating them 'Stable'. This means that risks may not lie with the banking sector, but that the consumer sector will be the key drag on growth. Report Links: AUD And CAD: Risky Business - March 10, 2017 Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 In the current environment, although we like to continue to be short the NZD against the yen, we are also shorting AUD/NZD once again. Beyond its uncorrelated nature, there are many reasons why this is an attractive cross to short: AUD/NZD tends to perform poorly when Chinese monetary conditions tighten. Therefore, the spike in Chinese repo rates could weigh on this cross. Furthermore, investors are very long the AUD relative to the NZD. This gives us confidence that this cross might be in overbought territory and that the 5.5% rally in AUD/NZD over the last 2 months may be exhausting itself. Finally, as we have mentioned before, domestic factors still favor the NZD, as kiwi house prices are rising at a faster pace than Aussie ones, which should put pressure on rate differentials. Report Links: Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Risks To The Cyclical Dollar View - February 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 The CAD is displaying some strength on the back of stronger oil prices, outweighing the pressure from a stronger USD. As mentioned last week, the trend for USD/CAD is still negative in the short term, as corroborated by a negative MACD trend. The greenback's seasonal behavior is also generally negative in April, which could buoy the CAD in the next month. Nevertheless, at the Bank of Canada's meeting in two weeks, Poloz is likely to continue displaying a dovish rhetoric, limiting the CAD's resilience. Similar to Australia, risks lie with the consumer sector, which is burdened by a huge debt load. This gives another reason for Poloz to stay off hikes for the time being and concentrate instead on promoting the implementation of macroprudential policies to regulate lending standards and mitigate housing market risks. Report Links: AUD And CAD: Risky Business - March 10, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017’s Greatest Hits - December 16, 2016 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 EUR/CHF now hovers around 1.07, clearing the implied floor by the Swiss National Bank. Recent data have been positive: The Zew survey for economic expectations reached 29.6, up from 19.4 in February. It is now at the highest level in 3 years. The KOF leading indicator came at 107.6, above expectations. Although it does seem that the Swiss economy is still improving, the SNB will stay resolute in its intervention for the time being. Indeed, this was the message of SNB Governing Board Member Andrea Maechler, who asserted that there was no limit on their expansion of FX reserves, and that the Swiss franc was "strongly overvalued". We will continue to observe how the Swiss economy develops. However, for the time being the SNB is likely to keep its floor in place. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017’s Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 USD/NOK has been relatively flat this week, even in the face of a rally in oil prices. This has been in part due to a phenomenon that should continue in the next months: an appreciation of the U.S. dollar against EM and commodity currencies. Furthermore, domestic factors should continue to weigh on the krone, as employment continues to contract and inflation is receding due to the stabilization of the krone. Indeed, Governor Olsen signaled that the Norges bank will likely leave rates unchanged for "a good while" due to these developments. Furthermore, oil could be at risk as well, as the market is starting to doubt the Russian commitment to its deal with OPEC. This, coupled with a slowdown in EM, could prompt a down leg in oil, hurting the NOK in the process. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017’s Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Swedish data came out strong: Retail sales annual growth remains unchanged at 2.7%; The producer price index grew at 7.5%; Consumer confidence for March was at 102.6, down from the previous 104.3. Interesting technical developments for the krona are pointing to further weakness. USD/SEK has rebounded from oversold levels and the MACD line is beginning to overtake the signal line. More importantly, the Coppock curve is rebounding, signifying a bullish trend. EUR/SEK is showing similar signs with the MACD pointing up and the Coppock curve rebounding. Interestingly, Swedish inflation expectations have substantially decreased this week which might give the Riksbank cover to remain dovish. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017’s Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Special Report

Highlights The years since the 2008 Global Financial Crisis have been dominated by the major central banks emptying their toolkits to fight off deflationary pressures and sustain even modest nominal growth rates. Extraordinary policy measues like quantitative easing, negative interest rates and "forward guidance" were all intended to be signals to expect nothing but stimulative monetary policy, even if there were brief pickups in growth or realized inflation rates. This helped suppress both bond yields and volatility, forcing investors to take on more risk to generate acceptable returns in fixed income markets. Now, however, there are signs that the world economy may finally be becoming a bit more "normal" after the years of malaise. While growth can hardly be described as booming, there are a growing number of countries that appear to have passed the worst phase of the excess capacity/deflation pressures that dominated the post-crisis era. This is creating more two-way risk with regards to central bank decisions than we have seen for some time. In this Special Report, we update one of our favorite tools to assess the potential for monetary policy changes, the BCA Central Bank Monitors. We present them in a chartbook format with a focus on the relationship to government bond yields. Feature An Overview Of The BCA Central Bank Monitors The BCA Central Bank Monitors are composite indicators that are designed to measure the cyclical growth and inflation pressures that can influence future central bank policy decisions. We created Monitors for the major developed economies: the U.S., Euro Area, Japan, the U.K., Australia, Canada and New Zealand. The list of data series used to construct the Monitors is not the same for each country, but the components generally measure the same things (i.e. manufacturing cycles, domestic demand pressures, commodity prices, labor market conditions, exchange rates, etc) Right now, the Monitors are rising in a coordinated fashion for the first time since 2011 (Chart 1 on Page 1). What is different in 2017 is that there is much less spare capacity in the developed economies than there was six years ago. For central bankers who still adhere to the Phillips curve tradeoff of unemployment versus inflation, tight labor markets alongside highly accommodative policy settings pose a problem. In the rest of this report, we show the individual Central Bank Monitors, along with measures of spare capacity and inflation for each country. We also show the correlations between the Monitors and changes in government bond yields, both before and after the 2008 Crisis. Correlations have shifted in the post-crisis era, but there are still some reliable relationships that can provide signals for bond investors. The broad conclusions: Japanese Government Bonds (JGBs) are the ideal country overweight in a world where all other developed economy central banks are witnessing rising cyclical pressures, while bonds in the U.K., Australia and New Zealand are likely to struggle as central banks in those regions become increasingly hawkish (Chart 2). Chart 1More Central Banks Are Under Pressure To Tighten Chart 2Tightening Pressures (Ex-Japan) ##br##Can Push Bond Yields Higher The Fed Monitor Is Pointing To Additional U.S. Rate Hikes Our Fed Monitor has just recently pushed above the zero line, indicating the need for the Fed to tighten policy (Chart 3A). The Fed already began raising the funds rate back in late 2015, but this was the beginning of normalizing the crisis-era policy settings rather than a move to offset improving U.S. cyclical conditions. The latter is now indeed happening, and it is perhaps no surprise that the Fed has just delivered 50bps of rate hikes in a span of three months. Chart 3AU.S.: Fed Monitor Chart 3BNo Spare Capacity In The U.S. Chart 3CThe Fed Monitor Is Most Correlated To ##br##Shorter Maturity U.S. Treasuries We still see the Fed pursuing a relatively gradual process of raising rates further in 2017, but in line with the current FOMC projections of another 50bps of tightening before year-end. Measures like the output gap and the unemployment gap (unemployment relative to the level consistent with stable inflation) show no spare capacity in the U.S. economy (Chart 3B). At the same time, core inflation continues to only grind higher and inflation expectations are also drifting up towards the Fed's 2% target. This can hardly be qualified as an "overheating" economy that needs a sharp tightening of monetary conditions, particularly with the still-expensive U.S. dollar not providing any stimulus. The correlations between our Fed Monitor and the year-over-year changes in U.S. Treasury yields (Chart 3C) have been extremely low since the 2008 Crisis - unsurprising with the Fed keeping the funds rate near zero for most of that period while also buying large amounts of Treasuries. While the correlations appear to be shifting on the margin, we still see the Treasury curve steepening first (via rising inflation expectations), then flattening later (through tighter monetary conditions). BoE Monitor Calling For Tighter U.K. Policy Our Bank of England (BoE) Monitor is at very elevated levels (Chart 4A), driven by a combination of improving production data and high inflation. There is much more bubbling beneath the surface, however. The more domestically-focused components of the Monitor are losing some upward momentum, while the inflation elements are also starting to top out as the big post-Brexit depreciation of the Pound is losing momentum. Chart 4AU.K.: BoE Monitor Chart 4BTight Capacity In The U.K. Chart 4CGilts Are At Risk From A More Hawkish Turn From The BoE This is creating a dilemma for the BoE - respond to high U.K. inflation with tighter monetary policy, or focus on the slowdown in domestic demand and do nothing? The BoE signaled in February that the biggest concern for policy was a slump in consumer spending led by lower real income growth on the back of rising inflation. Yet at the March policy meeting, one BoE member even voted to raise rates and others raised concerns about the elevated level of U.K inflation. With even policymakers unsure about their next move, the marginal swings in U.K. growth should have an even greater impact on Gilt yields. The U.K. economy is running around full capacity and both headline and core inflation are rising (Chart 4B). Somewhat surprisingly, the correlations between changes in Gilt yields and our BoE Monitor have actually increased since the 2008 Crisis (Chart 4C). This raises a potential risk for the Gilt market if the BoE decides that the U.K. economy is not slowing as much as it is expecting. For now, we continue to recommend a neutral stance on Gilts until there is greater clarity on the state of the economy. ECB Monitor Reflects A Less Deflationary Backdrop In Europe Our European Central Bank (ECB) Monitor has recently crept above the zero line for the first time in three years (Chart 5A). This is driven mostly by the current uptrend in headline inflation in the Euro Area, but also by the steady improvement in economic growth. Chart 5AEuro Area: ECB Monitor Chart 5BExcess Capacity in Europe Dwindling Fast Chart 5CStable Correlations Between The ECB Monitor & The Front End Of The Yield Curve The Euro Area is the one economy presented in this report where no indicator (either the output gap or unemployment gap) is pointing to a lack of spare capacity (Chart 5B). All of the rise in headline Euro Area inflation can be attributable to base effects related to last year's rise in oil prices and decline in the euro. The latest ECB projections call for core inflation to return to just under 2% in 2019, suggesting that there is no hurry to begin tightening monetary policy. Yet the ECB remains in an asset purchase program which is set to expire at the end of this year, so a policy decision must be made in the next 3-6 months. We expect the ECB to begin tapering its bond buying in the first quarter of 2018, with interest rate hikes to follow after the tapering has been completed. The ECB could raise rates before tapering to try and minimize the impact on Peripheral sovereign and corporate bond yields (it is buying both), although that would likely create a greater degree of tightening than the ECB would like before full employment is reached. Given the strong correlations between our ECB Monitor and much of the Euro Area yield curve (Chart 5C), however, we anticipate moving soon to an underweight stance on Euro Area bonds after our recent downgrade to neutral. BoJ Monitor: Nothing To See Here Our BoJ Monitor has been in the "easier policy required" zone for most of the past 25 years, barring a brief blip above the zero line that heralded the rate hikes in 2006/07 (Chart 6A). Inadequate growth and excess capacity remain the biggest problem with Japan's economy, preventing any meaningful upturn in inflation beyond that caused by higher commodity prices or a weaker yen. Chart 6AJapan: BoJ Monitor Chart 6BTight Labor Market, But Still No Inflation Chart 6CLonger-Maturity JGB Yields Have No Correlation To The BoJ Monitor Even with Japan operating at full employment, with an unemployment rate at 3%, there has barely been any acceleration in wages or core inflation (Chart 6B). The only way out of this for Japan is to keep monetary policy settings as easy as possible to ensure that there is enough growth to eat away at the remaining spare capacity in the Japanese economy. That means keeping both policy rates and the yen as low as possible, and hoping that this will cause enough of a rise in inflation expectations to lower real interest rates and boost domestic demand. As an added "kicker", the BoJ is even anchoring the long end of the Japan yield curve by targeting a 0% yield level on 10-year government debt - a policy that we do not expect to change anytime soon. We see Japan as a low-beta "safe haven" government bond market in an environment where other central banks are seeing some tightening pressures and Japanese bonds have virtually no correlation to the BoJ Monitor (Chart 6C). We continue to recommend an overweight stance on Japan within an overall defensively positioned government bond portfolio with below-benchmark duration exposure. BoC Monitor: No Big Need To Tighten In Canada Our Bank of Canada (BoC) Monitor has recently moved into positive territory (Chart 7A) , primarily due to some improvement in growth and higher commodity prices. Given the close linkages between the U.S. and Canadian economies, we include some U.S. growth variables in our BoC Monitor and these are also helping boost the indicator. However, there are no signs that the Canadian economy is overheating - unless you are trying to buy a home in Toronto - with both the output gap and unemployment gap not yet in positive territory (Chart 7B). Chart 7ACanada: BoC Monitor Chart 7BStill Not Much Inflation In Canada Chart 7CThe BoC Monitor Is Highly Correlated To Shorter-Maturity Canadian Bonds The BoC is maintaining a dovish bias at the moment. Some of that has to do with the uncertainty over the U.S. economic outlook, especially with regards to the fiscal and trade policies of the Trump administration. While a boost to U.S. growth via a fiscal easing could help support Canadian exports to the U.S., any move to renegotiate trade agreements involving the two countries could end up hurting the Canadian economy. Add to that the concerns over the bubbly valuations of Canadian real estate that could be pricked by even modest rate increases, and the BoC will likely not want to contemplate any early tightening of monetary policy. The higher correlations between our BoC Monitor and the front end of the Canadian yield curve (Chart 7C) suggest that a bear flattener would be the appropriate trade if and when the BoC does contemplate a rate hike. For now, however, we see that as a low-probability event and we are maintaining a neutral stance on Canadian bonds until there is greater clarity on U.S. growth and Trump's policy agenda. RBA Monitor: Higher Because Of Growth, Not Inflation Our Reserve Bank of Australia (RBA) Monitor has surged into the "tighter policy required" territory in recent months (Chart 8A), driven by higher commodity prices and stronger Asian export demand. Survey-based measures of inflation expectations are also part of the Monitor, and those have also been rising despite a lack of realized inflation in Australia (Chart 8B). The low inflation readings have been causing a bit of a problem for the RBA, given the tight labor market and that boost to Aussie demand from better Asian growth. This is especially true given the surprisingly soft readings on employment growth, consumer confidence and spending, all occurring against a persistent deceleration in core inflation. The RBA was focusing on the inflation story last year when it delivered some surprise rate cuts, and we still suspect that a lack of inflation pressure will keep the RBA on hold for at least the next few months. We are currently at a neutral stance on Australian government bonds, given these conflicting forces of better export growth but weakening domestic demand. The lack of an inflation threat could make Australia an outperformer in a world of rising bond yields. Given the surge in our RBA Monitor, however, we see some risk in looking at Aussie bonds as a potential safe haven market given upward pressures on yields in the U.S. and Europe. The correlations between Australian yields and the RBA Monitor are extremely high (Chart 8C), and have actually gone up in the post-crisis era. Chart 8AAustralia: RBA Monitor Chart 8BNo Inflation Pressures On The RBA Chart 8CAussie Bonds Across The Curve Are Highly Correlated To The RBA Monitor RBNZ Monitor: A Strong Case For A Rate Hike Our Reserve Bank of New Zealand (RBNZ) Monitor is strongly in positive territory (Chart 9A), led by the components focused on commodity prices and global growth. However, there is a fairly solid structural case for an RBNZ rate hike, given the lack of any spare capacity in New Zealand and inflation on the rise (Chart 9B). Chart 9ANew Zealand: RBNZ Monitor Chart 9BFull Employment & Rising Inflation In NZ Chart 9ANZ Bonds Are Vulnerable To Current Cyclical Pressures The RBNZ has been maintaining a dovish bias of late, although it has chosen to sight more "international" risks related to geopolitics, rather than domestic economic conditions. Perhaps this is nothing more than a fear of a potential shock outcome in the upcoming French elections, although it could also be worries that tensions between the Trump White House and China (or, worse yet, North Korea) could trigger a hit to demand for New Zealand exports to Asia. In the end, we think the RBNZ will be forced to a hike off the current record low interest rates as the next policy move. While we do not include New Zealand government bonds as part of our model fixed income portfolio, we do currently have a bearish rates trade on in our list of Tactical Overlay Trades, choosing to pay 12-month NZD OIS rates. We will maintain that recommendation, but we may look to add some bearish New Zealand bond trades, as well, given the strong correlation between our RBNZ Monitor and bond yields (Chart 9C). Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com

Highlights Beyond the healthcare vote and its implication for Trump's fiscal stimulus, other risks lurk in the background. Market complacency is at historical extremes but Chinese reflation is rapidly dissipating. The euro could benefit in this environment, especially as markets price in a Macron victory. Longer-term, the euro remains hampered by its two-speed recovery, which will limit the capacity of the ECB to lift rates. Stay long EUR/AUD, short USD/JPY and NZD/JPY. Feature The dollar correction continues. The recent wave of dollar weakness has been dubbed a reversal of the "Trump trade". There is some truth to this. The difficulty President Trump and House Speaker Ryan are facing to pass the American Health Care Act (their replacement for Obamacare) is raising questions about how much tax cuts and infrastructure spending Trump will actually be able to implement. Even if the House votes in favor of the new bill (which is still an unknown at the time of writing), the Senate remains a question mark. So the narrative goes, if the Trump stimulus is at risk, the economy will be weaker, the Fed will not hike interest rates as much as anticipated, and the dollar will falter. While there is validity to this thesis, we think the picture is more nuanced. The potential for less fiscal stimulus in the U.S. is a real worry, but our main concern is that the global industrial sector's growth improvement does not continue the way investors expect. In this environment, the dollar is likely to perform poorly against European currencies and the yen, but hold its own against EM and commodity currencies. We are positioned for such a development. These trends would be reminiscent of the kind of dollar dynamics that emerged in late 2015 / early 2016. Chinese Reflation Matters Too! What underpins our thesis? As our sister service, Global Alpha Sector Strategy, has highlighted in this week's report, the Yale Crash Confidence index has hit 100%, indicating that all of the respondents surveyed expect the stock market to go up in 2017. Moreover, the Minneapolis Fed's market-based implied probability of a 20% or more selloff in the S&P 500 has fallen below 10%, the lowest level since 2007.1 With this high degree of complacency, a rollover in the global economic surprise index represents a major risk for the asset most levered to the global industrial sector (Chart I-1). To us, the key behind the 2016 rebound in global industrial activity was China. While Chinese growth is not about to experience a sharp slowdown, it is unlikely to improve further. To begin with, Chinese monetary conditions are already rolling over (Chart I-2). The big improvement in this indicator in 2016 was the crucial ingredient behind the rebound in global trade, global industrial activity, and all the assets levered to these phenomena. Chart I-1Surprises Are Not ##br##Growing Anymore Chart I-2Chinese Monetary Conditions ##br##Are Tightening We are seeing tentative signs of a mini liquidity crunch emerging in the Chinese interbank system. Seven-day repo rates, a key benchmark for Chinese lending terms, have surged from 3.8% at the end of last week to 5.5% on Tuesday, before settling at 5%, the highest level in two and a half years (Chart I-3). By allowing this volatility, policymakers are most likely sending a warning shot to the Chinese real estate sector, which has been a key driver of Chinese metal demand in 2016. This sector alone accounts for 20% and 32% of global refined copper and steel consumption, respectively. Also, as we have highlighted previously, fiscal stimulus was another key factor behind the floor put under Chinese industrial production and fixed asset investment last year. However, Chinese fiscal spending peaked at a 25% yoy growth rate in November 2015 and is now near 0%. This suggests that a key source of stimulus in China has been removed. It is true that Chinese fiscal stimulus is heavily conducted through credit policy. In this context, the recent rise in Chinese borrowing rates does indicate that the Chinese authorities are not intent in jacking up growth anymore. The reduced growth target for this year is a clear re-affirmation of this change in focus. We are seeing signs that these adjustments are starting to bite. The growth rate of new capex projects started has rolled over and is now flirting with the zero line. As Chart I-4 highlights, this indicator provided a very positive signal for the AUD last year and is now forewarning potential risks. Chart I-3Is The PBoC Sending A Message##br## To The Real Estate Industry? Chart I-4Big Risk For##br## The AUD Additionally, the Canadian venture exchange, an index of high risk, small-cap Canadian equities has historically displayed a tight correlation with Chinese GDP growth (Chart I-5). This market is experiencing a negative divergence between its MACD and prices, potentially an early sign that investors are beginning to worry about China. Risk assets globally are not ready for these developments. In fact, EM spreads are hovering near cycle lows, junk spreads are extremely narrow, the VIX is also near cycle lows, and our global complacency indicator suggests that investors are not ready for negative Chinese surprises (Chart I-6). Not only would a negative surprise out of China cause a repricing of all these factors, but periods of market stress - even shallow stress - are associated with rising correlation among assets and among individual equities. The low level of correlation among S&P 500 constituents has been an important factor behind the fall in the VIX and the rise in margin debt. A rise in risk aversion could get turbo-charged by a rectification of these low correlations, prompting a temporary wave of debt liquidation (Chart I-7). Chart I-5A Key China Gauge Is Losing Momentum Chart I-6Complacency Abounds Chart I-7Correlation Risk In this environment, U.S. stocks could easily correct by 5% to 10%. EM stocks may have even more downside as they are more directly exposed to the biggest risk factor: China. From a currency market perspective, this means that defensive currencies could outperform pro-cyclical ones. This is why we remain long the USD against a basket of commodity currencies, but short against the yen - the most countercyclical currency of all. We also are long the euro against the AUD. These views make our publication more cautious about the near-term outlook than BCA's house view. Bottom Line: Risks beyond the outlook for tax cuts in the U.S. lurk in the background. The Chinese authorities have moved away from stimulating the economy, and some early cracks are showing. A collapse is not in the cards, but given the high degree of complacency present across markets, a disappointment in a supposedly perfect environment would create a headwind for EM and commodity currencies but boost the defensive EUR and JPY. Why Long EUR/AUD Tactically? While the negative view on the AUD fits cleanly in the narrative described above, our motivation to be long the euro is more multifaceted: The euro area has negative nominal interest rates and a current-account surplus of 3.3% of GDP, meaning it exhibits key characteristics of a funding currency. In a risk-off event where unforeseen FX market volatility rises, funding currencies perform well. We expect a further normalization of the French OAT / German bunds spread as we get closer to the French election. Macron is beating Le Pen by more than 20% in second-round polling (Chart I-8). This gap is five times greater than the advantage Clinton held over Trump at a similar point in the U.S. presidential campaign. As we argued in a joint Special Report co-published with our Geopolitical Strategy team seven weeks ago, this kind of advantage is highly unlikely to be overcome by May 7. Thus, the euro area break-up risk premium can narrow between now and then.2 Finally, the number of investors expecting rising short and long rates has bottomed in Europe relative to the U.S. Historically, this indicator has provided valuable lead on EUR/USD. It is currently painting a tactically bullish story for the euro (Chart I-9). Moreover, in the event of market stress, with investors pricing in two more rate hikes by year end in the U.S., but none in Europe, the scope for temporary downward revisions in the U.S. is higher than in Europe. This could put more upward pressure on this indicator and therefore, the euro. Chart I-8Macron: En Marche! Chart I-9Short-Term Euro Upside Together, these factors suggest that the euro could rebound toward 1.12 before the middle of 2017. Again, our favored currency to play this move is against the AUD. EUR/USD: Short-Term Gain But Long-Term Pain Chart I-10Monetary Policy Is The ##br##Common Shock In Europe What about the longer term dynamics for the euro? We are more skeptical of the common currency's ability to rally durably, and we are expecting the euro to fall below parity by mid-2018. Based on our months-to-hike indicator, the market expects the ECB to hike by the fall of 2018. We disagree and think the first hike could come much later. While the economic rebound in Europe is real, it seems to be very dependent on the high degree of easing that has been put in place by the ECB. As Chart I-10 illustrates, the credit impulse - a measure underpinning domestic economic activity - and the euro have moved very closely together. While we do not imply that the credit impulse's rebound has reflected the fall in the euro, their tight co-movement has been driven by a similar factor: easy money. Thus, a removal of that easy money could prompt a reversal of that domestic improvement. Even more crucially, the conditions in the periphery are what really matters to the ECB. At the beginning of the millennium, the ECB was acting as Germany's central bank, keeping rates too low for the periphery, but alleviating Germany's deflationary tendencies. Today, the ECB behaves as the periphery's central bank. Germany seems ready to handle higher interest rates, but the same is not true for most other European countries. To begin with, even within the core, wage dynamics remain tepid. French and Dutch wages continue to slow while Austrian wage growth has collapsed near 0% (Chart I-11A). If the situation is poor in most core countries, it is dismal in the periphery. Wages are still contracting in Greece and Portugal, and growing at a sub 1% pace in Spain and Italy (Chart I-11B). These differentiated wage trends reflect the fact that worker shortages in the periphery are simply inexistent, while in Germany, they are commonplace (Chart I-12). Chart I-11AOnly Germany Is Witnessing##br## Strong Wages... Chart I-11BOnly Germany Is Witnessing ##br##Strong Wages... Chart I-12...Because Germany Has The##br## Tightest Labor Market.... As a result, the dynamics in core inflation remain muted. German core inflation has been extremely stable near 1% for six years now, but is hitting record lows levels of 0.3% in France (Chart I-13A and Chart I-13B). Core inflation also remains near 0% in most peripheral nations. Chart I-13A...Explaining Europe's Bifurcated Core Inflations Chart I-13B...Explaining Europe's Bifurcated Core Inflations When the Fed first increased rates in 2015, U.S. wages were growing at 2%. This is a far cry from current levels in Europe. Moreover, the first U.S. rate hike was a mistake considering the subsequent deceleration in growth and poor performance of risk assets. Thus, the Fed experience is probably not an example for the ECB to emulate. Moreover, rising interest rates represent a risk for debt servicing ratios in many European countries, limiting the ECB's ability to hike if nominal growth does not pick up further. The Netherlands, Belgium, Portugal, and France rank amongst the countries with the highest private-sector debt servicing costs as a percent of income. Meanwhile Italy and Portugal score extremely poorly when this metric is applied to the public sector (Chart I-14). The Italian and Portuguese cases are especially worrisome as rising stress caused by rising rates will further lift government rates. An argument has also been made that for the ECB, what matters is the headline rate of inflation. We would argue that since Draghi became the leader, this inflation measure is less relevant. But nonetheless, let's temporarily entertain this premise. It has also been argued that if European and U.S. statistical agencies treated housing similarly, inflation on both sides of the Atlantic would be the same. As Chart I-15 illustrates, this is no longer true. Chart I-14Debt Service Payments Are ##br## A Problem In Europe Chart I-15European Inflation Is Lower, ##br##No Matter What This line of reasoning also forgets that since 2014, the U.S. has endured a 22% appreciation in the trade-weighted dollar, which could have already curtailed nearly 1% to U.S. GDP growth, a significant amount of monetary tightening. However, the euro has greatly depreciated over this time frame, representing a large monetary easing. Due to these highly divergent monetary backdrops, one can deduce that endogenous inflationary pressures are much greater in the U.S. than in the euro area. All these factors suggest that it will be hard for the ECB to increase rates by the end of 2018. Thus, on a cyclical basis we would fade this recent massive fall in the ECB's months-to-hike metric (Chart I-16). On the U.S. ledger, the labor market is clearly tightening and the U6 unemployment rate is now congruent with levels where wages have gained traction in previous cycles (Chart I-17). This suggests that the market is correct to expect the Fed to hike much more aggressively in the coming years. In fact, while the near future might be filled with political complexity, we continue to expect fiscal stimulus to materialize in the U.S by 2018, suggesting upside risk to the Fed's forecast. Chart I-16Too Soon! Chart I-17The U.S. Labor Market Is Tight Finally, equilibrium real rates in Europe are probably substantially lower than in the U.S. Not only have European interest rates been historically lower than in the U.S., but also, slower population growth alone would justify lower neutral rates. This highlights that the scope for the ECB to hike is limited compared to the Fed. These bifurcated monetary dynamics will continue to support the USD on a 12-18 months basis, and as a corollary, hurt the euro despite its apparent cheapness on a PPP basis. Bottom Line: The months-to-hike in the euro area has fallen to less than 20 months. While Germany could handle higher rates, poor wage and core inflation dynamics in the rest of the euro area suggest it is still much too early to increase rates. Moreover, without a more significant pick-up in growth, many European nations will face dire debt-servicing situations if the ECB hikes rates durably. Meanwhile, the U.S. is moving closer to full employment, a situation warranting higher rates. The euro could fall below parity by mid-2018. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Global Alpha Sector Strategy Weekly Report, "Caveat Emptor" dated March 24, 2017 available at gss.bcaresearch.com 2 Please see Foreign Exchange Strategy and Geopolitical Strategy Special Report, "The French Revolution" dated February 3, 2017 available at fes.bcaresearch.com and gps.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 March weakness has been because of a mix of monetary and fiscal disappointments. The Fed's "unhike" initiated the downtrend as markets were surprised by the dovish tone of the Fed's communications. Now, President Trump and his team are facing difficulties passing the American Health Care Act. Markets are extrapolating this difficulty to the realm of fiscal policy in general. Nevertheless, it is unlikely for the DXY to breach the 98-99 support level this month. The stronger current account number of USD -112.4 billion was supported by high foreign income, suggesting a key warning sign for the USD cyclical bull market is not present. Stronger new home sales monthly growth of 6.1% highlights that domestic economic activity remains robust, meaning the Fed is unlikely to disappoint over the life of the business cycle. Report Links: USD, Oil Divergences Will Continue As Storage Draws - March 17, 2017 Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Political risks have been exaggerated in Europe, with the Dutch and Austrian elections confirming that populist successes in Europe are overstated. As such, the French election will likely be market-bullish with a Le Pen defeat. This entails a further normalization of OAT / Bund spreads, and a short-term bullish outlook for the euro, which is likely to settle above 1.10. Corroborating this view, the MACD is currently above 0 and outpacing the signal line, a bullish development. Inflationary pressures are building up in Europe with German PPI at 3.1% annually in February. However, outside Germany, even the core, let alone the periphery, seems to be struggling, with poor wage growth. The ECB will therefore need to stay easy for longer to protect the euro area's weakest members, capping the long-term upside to rates and the euro. Report Links: Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 The French Revolution - February 3, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 The yen has continued to rally, with USD/JPY trading below 111 over the last couple of days. We continue to be bullish on the yen on a tactical basis, as we believe that the global industrial sector will fall short of investors' expectations. This is an environment where the dollar will probably appreciate against EM currencies, but falter against the yen. On a cyclical basis we remain yen-bearish, as U.S. rates should continue to go up, while Japanese rates will continue to be anchored around 0%. The Bank of Japan will continue with this policy, as the depreciation of the yen has given a boost to exports, which are now growing at 11.3% on a yearly basis, as well as to the economy as a whole, which should yield higher inflation expectations over time. Report Links: Et Tu, Janet? - March 3, 2017 JPY: Climbing To The Springboard Before The Dive - February 24, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 The British pound rallied on Tuesday following the unexpected surge in headline inflation in February from 1.8% to 2.3%. This number is significant, because inflation has broken through the BoE's target. The central bank remains cautious, as the MPC pointed out that the rise in inflation is not domestic, but rather a reflection of the fall in the pound. However, we believe that internal inflationary pressures might start to emerge: the U.K. economy is doing much better than expected and the labor market is tight. Recent data highlights this, and opens the possibility that the pound could rally, particularly against the euro: Retail sales growth and retail sales ex fuel growth came in at 3.7% and 4.1% respectively, outperforming expectations. The CBI Distributive Trades Survey monthly growth also beat expectations, coming in at 9%. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 As mentioned last week, the AUD's strength was a temporary feat. Before declining, the Aussie was initially lifted by high house price growth of 7.7% annually for 4Q2016, really surpassing expectations. The RBA minutes highlighted a need for the current monetary policy to remain very accommodative: labor market conditions remain mixed, household perceptions of personal finances is at average levels, wage growth remains subdued, and inflation is expected to rise only slowly. The outlook for the AUD is therefore likely to remain poor. Corroborating this view is a contracting Westpac Leading Index number of -0.1% that may be foretelling weak data. Report Links: AUD And CAD: Risky Business - March 10, 2017 Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Yesterday, the RBNZ kept its policy rate unchanged at 1.75%. Governor Graeme Wheeler once again asserted that the kiwi remains overvalued, although he welcomed the recent depreciation of the trade-weighted kiwi. More depreciation might be in the cards, particularly against the U.S. dollar and the yen. Global FX Vol stands at very low levels, thus any uptick could severely hamper the NZD, a carry currency. Furthermore, the tightening in Chinese monetary conditions will likely weigh on commodity currencies. Nonetheless, the NZD could perform well against the AUD as domestic inflationary pressures in Australia are much weaker than in New Zealand. Additionally, the tightening in Chinese monetary conditions should be more harmful for the AUD, given that iron is more sensitive to economic activity than dairy products. Report Links: Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Risks To The Cyclical Dollar View - February 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 The oil-based currency has sustained the recent oil shocks well, helped by the USD's weakness. Indeed, Canadian data has generally been positive: Manufacturing shipments increased 0.6% monthly in January, much above the expected -0.4%; Wholesale sales increased 3.3% in January on a monthly basis; Monthly retail sales picked up to 2.2% and 1.7% when autos are excluded; The 2017 government budget marginally loosened fiscal policy. As the greenback is likely to display further downside, the short-term outlook for USD/CAD is negative. This is corroborated by the negatively trending MACD line. However, Governor Poloz is likely to maintain a dovish tilt relative to the Fed, signifying longer-term CAD weakness. Report Links: AUD And CAD: Risky Business - March 10, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Following the surge in the Euro, EUR/CHF has moved back to 1.07. This has eased some pressure off the SNB, which was active in the foreign exchange market to preserve the floor in this cross. The early returns of this policy seem positive, as data is showing a gradual recovery in Switzerland: The SNB's trimmed mean core inflation measure (TM15) is now in positive territory and continues to rise. Swiss PMI has surged so far this year, and now stands at the highest level since 2011. So far these improvements are not enough to prompt a change in policy by the SNB, as inflation needs to be sustained at a higher level and corroborated by wages. Nevertheless, we will continue to monitor economic developments in Switzerland to assess whether the SNB could remove its floor under EUR/CHF. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 USD/NOK has been relatively flat this week, as the sharp decline in oil has been offset by a downturn in the U.S. dollar. The outlook for the krone remains poor though, as the economy is weak, and inflation is falling quickly. Recent data illustrates this: After a gradual slowdown, non-financial business credit is now heading into outright contraction. Employment is contracting at a 1% rate, while wages are contracting at a 4% pace. Core inflation has plunged to 1.5% from its peak of 4% around 6 months ago. This poor economic outlook leads us to believe that the dovish bias of the Norges Bank will stay entrenched for the time being, putting downward pressure on the krone. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Inflationary pressures continue to emerge in Sweden. We believe these pressures are likely to pick up further. USD/SEK has broken down below a key trend line that has underpinned its rally since May 2016, suggesting that as the euro continues to rebound, the SEK will also outperform the USD. However, it remains to be seen if the SEK can outperform the euro: while the SEK tends to be more sensitive to the dollar's weakness than the euro, the Riksbank is likely to want to make sure that the early signs of inflation in Sweden do indeed generate a durable way out of any deflationary tendencies in this economy. This means that the Swedish central bank is likely to try to weigh on any strength in the SEK, especially against the euro. However, as inflation is indeed coming back, the Riksbank will likely be forced to abandon its super-dovish stance later this year. The SEK will ultimately rally further against the euro on a 12-18 months basis. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights The global economy has turned the cap and is on a sustainable uptrend. Yet, the AUD and CAD have over-discounted the improvements and are at risk of suffering a disappointment if global manufacturing activity remains firm but does not accelerate much. Moreover, the Australian and Canadian domestic economies remain too weak to justify rates moving in line with the Fed. Rate differentials will continue to weigh on both currencies. While the CAD is cheaper than the AUD and warrants an overweight position versus the Aussie, we are adding it to our short commodity currency basket trade. The ECB will not ease further, but it will not tighten this year either. Feature Since their February highs, the Australian and Canadian dollars have declined by 2.7% and 3.6% respectively. In May 2016, we wrote that commodity currencies could continue to perform well, but that ultimately, this strong performance would only prove transitory and that the AUD and the CAD would once again resume their downtrends.1 Is this recent weakness the beginning of a more pronounced selloff? We believe the answer is yes. How Great Is The Global Backdrop? Much ink has been spilled regarding the improvement in the global industrial sector. Global PMIs have perked up the world over, semi-conductor prices have been booming, metal prices have been on a tear, and Chinese excavator sales have been growing at a 150% annual rate (Chart I-1). It would seem that the world economy is out of the woods. This is true, but asset markets are not backward looking, they are forward looking. The improvement in global economic conditions that we have witnessed has driven the impressive rally in stocks, EM assets, commodity, and commodity currencies in 2016. But what matters for future asset markets' performance, and especially growth sensitive currencies like the AUD and the CAD, is future global growth. Where do we stand on that front? We do not expect an economic relapse like in 2015 and early 2016. Some key elements have changed in the global economy, suggesting it is not as hampered by deflationary forces as it once was: DM industrial capacity utilization has improved (Chart I-2). Also our U.S. composite capacity utilization indicator that incorporates both the manufacturing and service sectors has now moved into "no slack" territory. This suggests that deflationary forces that have so negatively affected the DM economy in 2015 and 2016 are becoming tamer. Chart I-1Signs Of An Economic Rebound Chart I-2Improving Global Capacity Utilization Commodity markets are much more balanced than in 2015-2016. Not only has excess capacity in the Chinese steel and coal sector been drained, but the oil market has moved from being defined by excess supply to a surplus of demand (Chart I-3). This suggests that commodities are unlikely to be the same deflationary anchors they were in the past two years. The global contraction in profits is over. Profits are a nominal concept, and in 2015 and 2016, U.S. nominal growth hovered around 2.5%, in line with the levels registered in the 1980, 1990, and 2001 recessions (Chart I-4). As a residual claim on corporate revenues, profits display elevated operating leverage. Thus, nominal GDP growth moving from 2.5% to 4% on the back of lessened deflationary forces will continue to support profits. Chart I-3Oil: From Excess Supply To Excess Demand Chart I-4Last Year Was A Nominal Recession This also means that the rise in capex intentions that began to materialize last summer is likely to genuinely support capex growth and the overall business cycle in the coming quarters, especially in the U.S. (Chart I-5). Additionally, the inventory cycle that has weighed on EM and DM economies is now over (Chart I-6). While growth is likely to be fine based on these factors, for the AUD and CAD to move higher, growth needs to accelerate further. The problem is that based on our Nowcast for global manufacturing activity, things are as good as they get now (Chart I-7). Chart I-5Improving DM ##br##Capex Outlook Chart I-6Inventories: From ##br##Drag To Boost Chart I-7If Global Industrial Activity Doesn't ##br##Improve, CAD and AUD Are Toast In China, which stands at the crux of the global manufacturing cycle, we see the following factors hampering further improvements: The Chinese fiscal impulse has rolled over. Fiscal stimulus does impact the economy with some lags. The peak in the Chinese boost was reached in November 2015, with government expenditures growing at a 24% annual rate, but today, they are growing at a 4% rate. The deleterious effect on growth of this tightening may soon be felt. Chinese liquidity conditions have deteriorated. Interbank borrowing rates are already rising (Chart I-8), and the PBoC has drained an additional RMB 90 billion out of the banking system this week alone. These dynamics could be aimed at cooling down the real estate bubble in the country. Falling activity in that sector would represent a significant drag on the industrial and commodity sectors globally. Chart I-8Tightening Chinese Liquidity Conditions Chart I-9The NZD Weakness Should Be A Bad Omen The fall in Chinese real rates may have reached its paroxysm in February. Commodity price inflation may have hit its peak last month, suggesting the same for Chinese producer prices. A slowing PPI inflation will raise real borrowing costs in that economy and further tighten monetary conditions. Corroborating these risks, Kiwi equities, a traditional bellwether of global growth continue to buckle down. In fact, the New Zealand dollar is offering the same insight. Being the G10 currency most sensitive to the combined effect of wider EM borrowing spreads and commodity prices, its recent fall may presage some problems in these spaces (Chart I-9). To be clear, we are not expecting a wholesale collapse in growth. Far from it, but an absence of acceleration or a mild deceleration, could have troubling effects on commodities. The case of oil this week is very telling. Inventories have been going up, but the frailty of the oil market was mostly a reflection of the extraordinary bullish positioning of investors (Chart I-10, left panel). The same is true for copper, investors are very long and thus, vulnerable to mild growth disappointments (Chart I-10, right panel). Chart I-10AInvestors Are Bullish Industrial Commodities Chart I-10BInvestors Are Bullish Industrial Commodities Oil is not the only commodity experiencing a large accumulation in inventories. China, the key consumer of metals, is now overloaded with large inventories of both iron ore and copper (Chart I-11). This combination of high bullishness and rising inventories represents a risk for metals, especially if the positive growth impulse in China slows somewhat from here. Chart I-11China Has ##br##Hoarded Metals Chart I-12Can Growth And Reflation Surprises Increase##br## As Policy Becomes Less Easy? Adding to these risks is the Fed. The Fed is on the path to increase rates a bit more aggressively than was recently anticipated by markets. U.S. real rates are responding in kind, and key gauges like junk bonds, gold, or silver are also highlighting that global liquidity conditions may begin to deteriorate at the margin. While this tightening is not a catastrophe, it is still happening in an environment of elevated global leverage and potentially decelerating growth. This is not the death knell for risk assets, but it does represent a risk for the asset classes that are not pricing in any potential rollover in the elevated level of global surprises and reflation (Chart I-12). Commodity currencies are not ready for this reality. To begin with, positioning on the key commodity currencies has rebounded substantially, and risk reversals on these currencies as well as EM currencies are at levels indicative of maximum bullishness amongst investors. Also, the Australian dollar is expensive relative to its fundamentals, including the terms of trade. This makes the Aussie very vulnerable to small shocks to metal or coal prices (Chart 13, left panel). The CAD is not as pricey as the AUD, but nonetheless, it has lost its previous valuation cushion (Chart I-13, right panel). It also faces its own set of risks. Chart I-13ANo Valuation Cushion In CAD And AUD Chart I-13BNo Valuation Cushion In CAD And AUD This set of circumstance highlights that the room for disappointment in these currencies is now large. Bottom Line: While 2016 was a dream come true for investors in commodity currencies, 2017 may prove to be a tougher environment. Global growth is not about to plunge, but for commodity currencies to rally more, global manufacturing activity needs to accelerate further. Here the hurdle is harder to beat. Not only is the Chinese reflationary impulse slowing exactly as the global manufacturing sector hits exceptional levels of strength, but the Fed is also marginally tightening its stance. This means that expensive currencies like the BRL and AUD, as well as the cheaper but still vulnerable CAD could suffer some downside if industrial growth temporarily flattens, an event we judge more likely than not. Domestic Considerations Chart I-14We Build Houses In Canada When it comes to the AUD and the CAD, global risk is skewed to the downside, but what about domestic considerations? Here again, signs are not as great as one might hope. When it comes to Canada, the capacity to withstand higher rates is limited. The elephant in the room is the risk posed by the U.S. border adjustment tax. BCA thinks that this tax could be implemented in a diluted form, one were apparels, food, energy, etc. are exempt from the deal. However, the industries representing the American "rust-belt" are likely to be fully covered. This means that machinery and cars in particular could be the key targets of the BAT. This is a huge problem for Canada. Take the car industry as an example. Canada exports C$80 billion in vehicles and parts to the U.S., or 15% of its merchandise exports, nearly 4% of GDP. The potential hit from this tax on the country could be large. Also, the Canadian economy is even more levered to house prices that the Australian one. As Chart I-14 illustrates, the share of residential investment in Canada is much higher than in Australia, despite the slower growth of the population in Canada than in the Australia. Additionally, Canadian consumption is much more geared to housing than in Australia. Canadian households are experiencing slower nominal and real wage gains than their Australian counterparts. Yet their consumption per head growth is similar to that of Australia, and their confidence is substantially higher, reflecting a stronger wealth effect in Canada than in Australia (Chart I-15). Furthermore, despite the rebound in commodity prices and profits in 2016, Canadian and Australian credit growth have been slowing sharply (Chart 16, top two panels); however, Canada suffers from a higher level of debt service payment than Australia, despite the fact that the Canadian household debt to disposable income is 170% versus 185% in Australia (Chart I-16, bottom panel). These factors amplify the negative potential of higher interest rates in Canada relative to Australia. But Australia also suffers from its own ills. Total hours worked continue to deteriorate in that country and job growth is even more heavily geared to the part-time sector than in Canada. Additionally, while Canada will benefit from a small amount of fiscal expansion in the coming years, Australia is tabled to experience a large degree of fiscal austerity (Chart I-17). In this context, it will be difficult for the Australian labor market to outperform that of Canada. Chart I-15Canadian Households Are ##br##More Levered To Housing Chart I-16Slowing Credit Growth In ##br##Canada And Australia Finally, while the Canadian core CPI is elevated at 2.1%, this largely reflects pass-through from the previous collapse in the CAD, and this is expected to dissipate as wage growth remains tepid at 1.2%. But the Australian situation is even more troubling. Australia has been incapable of generating much inflation, and the fall in hours worked suggests that the labor market may be easing, not tightening. With the 10% increase in the AUD from its trough in 2016, inflation is unlikely to rise enough to prompt the RBA to become much more hawkish in the coming months. Thus, we think that both Canadian and Australian rates will continue to lag U.S. ones, putting more downward pressures on the CAD and the AUD versus the USD, despite the recent improvement in trade balances in both nations. (Chart I-18). Moreover, even if the decline in Australian interest rate differentials relative to the U.S. were to be less pronounced than in Canada, the AUD is much more misaligned with differentials than the CAD, adding to the Aussie's vulnerability. Chart I-17Fiscal Policy: Canada Eases, ##br##Australia Tightens Chart I-18Rate Differentials Will Continue##br## To Help The USD Bottom Line: Domestic conditions remains challenging for Australia and Canada. In both nations, debt service payments are already elevated, suggesting it will be hard for the central bank to increase rates without prompting accidents. While Australia seems less geared to the housing sector than Canada, its labor market dynamics are poorer, it faces a more austere fiscal policy, and it has trouble generating any inflation. We expect rate differentials to continue to move against both the CAD and the AUD versus the USD. Investment Conclusions At this point, the CAD and AUD are essentially entering an ugly contest. For both of these currencies, the global backdrop could prove to be more difficult in 2017 than in 2016. Moreover, both these currencies are handicapped by fundamental domestic issues that will further prevent rates to rise vis-à-vis the U.S. As such, we are now adding the CAD to our short commodity currency basket trade against the USD. AUD/USD may move toward 0.65-0.60 and USD/CAD may rally toward 1.40-1.45. Comparatively, both the AUD and CAD suffer from different but equally important handicaps. The only thing that would put the CAD at the nicer end of the ugly contest are its valuations. Our PPP model augmented for productivity differentials continues to show that the CAD is cheap against the AUD, corroborating the message of our long-term fair value models (Chart I-19). Also, as we highlighted above, CAD is more in line with its IRP-implied fair value than the AUD. We therefore recommend investors overweight the CAD vis-à-vis the AUD. A Few Words On The ECB Yesterday, Draghi struck a cautious tone in Frankfurt. While he acknowledged that deflationary risks in the euro area have decreased relative to where they stood last year, the governing council still thinks downside risks, even if of a foreign origin, slightly overshadow upside risks to its forecast. While the ECB feels that there is less of a need to implement additional support to the economy in the future, it judges the current accommodative setting to still be warranted. We agree. It is true that headline inflation in Europe has moved to 2%, but core inflation, which strips the very important base effect in energy prices that has lifted HICP, remains flat at low levels. Moreover, wage growth in the euro area remains tepid, confirming the lack of persistent domestic inflationary pressures in Europe (Chart I-20). Thus, the ECB elected to maintain asset purchases to the end of December at EUR60 billion per months. Rates are also unlikely to rise until after the end of the purchase program. In this environment, while the trade-weighted euro may move higher, the cyclical outlook continue to be negative for EUR/USD as monetary policy divergences between the U.S. and Europe will grow as time passes. On a 3-month basis, if we are correct that global growth may not accelerate further, the potential for a correction in EM and commodity plays could provide a temporary fillip to the euro. As markets currently priced in less rate hikes from the ECB than the Fed, the scope for pricing out the anticipated rate hikes is lower in Europe than in the U.S. if risk assets experience a correction within a bull market. This means that DXY may weaken or stay flat even if the trade-weighted dollar rises during that time frame. Chart I-19AUD / CAD Is Expensive Chart I-20The ECB's Dilemma Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, "Pyrrhic Victories" dated April 29, 2016 available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The U.S. economy continues to show resilience with the ADP employment change crushing expectations by 108,000. Although the USD did not react proportionately to this specific news, this is only a firmer signal of the confirmation for a rate hike next week. With the market pricing in almost a 100% probability of a hike, the Fed is unlikely to disappoint. What matters now is the messaging around the hike. In this regard, Trump's aggressive fiscal stance and the economy's consistent resilience is making a good case for the Fed to remain supportive of its forecasts. On a technical basis, the MACD line for the DXY is above the signal line, while also being in positive territory. Momentum is therefore pointing to a strong upward trend for the dollar in the short term. Report Links: Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Risks To The Cyclical Dollar View - February 3, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 The ECB left its policy rates and asset purchase program unchanged. Although President Draghi acknowledged the euro area's resilience as risks have become "less pronounced", he also noted that risks still "remain tilted to the downside". In the press release, the Governing Council continued to highlight that they continue to expect "the key ECB interest rates to remain at present or lower levels for an extended period of time, and well past the horizon of the net asset purchases". The message is therefore mixed. Growth is expected to remain resilient in the euro area, but significant domestic slack and global factors have forced the ECB to remain cautious. Cyclical risks to the euro are more to the downside than to the upside in the current environment. Report Links: Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 The French Revolution - February 3, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent Japanese data has been mixed: Machine tool orders yearly growth came in at 9.1%, the highest level since the third quarter of 2015. Labor cash earnings yearly growth came above expectations at 0.5%. However GDP growth was disappointing, coming in at 1.2% against expectations of 1.6%. We continue to be bearish on the yen on a cyclical basis. Although there has been some improvement, economic data has still been too tepid for the Bank of Japan to even consider rolling back some of its most radical policies. After all, the BoJ has established that they now have a price level target instead of an inflation target, which means that inflation would have to overshoot 2% for a significant period of time in order to switch from their easing bias. Report Links: Et Tu, Janet? - March 3, 2017 JPY: Climbing To The Springboard Before The Dive - February 24, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 After the vote in the House of Lords, Theresa May has been dealt yet another blow to her Brexit hopes as the upper house of the U.K. voted for giving parliament veto power over the final exit deal of Britain from the European Union. This news have been positive for the pound at the margin, as the perception of softer Brexit increases. The prime minister will now appeal this decision to the House of Commons. If she is defeated here, the pound could rally significantly. On the economic side, recent data has been disappointing: Market Services PMI not only went down from the previous month but also underperformed expectations, coming in at 53.3. Halifax house prices yearly growth came in at 5.1%, underperforming expectations. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 As expected, the RBA left its cash rate unchanged at 1.5%. The currency was little changed from this announcement. However, following last week's depreciation, the AUD followed through with further depreciation on Wednesday due to a strengthening greenback. This affected the AUD twofold: the appreciating dollar added pressure on the AUD, and on commodity prices which further exacerbated the AUD's decline - copper prices are down more than 4% and iron ore futures are down almost 3%. Risks are to the downside for the AUD: declining copper and iron ore prices foretell that the AUD's decline may continue; China's regulation on coal imports and energy production will further damage Australia's export market. On a shorter-term basis, the MACD line is below the signal line and indicates negative momentum. Additionally, the MACD line has breached negative territory, adding further downward momentum. Report Links: Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Risks To The Cyclical Dollar View - February 3, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 The kiwi continues to fall, and has now lost all of the gains from earlier this year. The outlook for the NZD against other commodity currencies is puzzling: on the one hand the NZD is very sensitive to emerging market spreads, which means that it would be the primary victim of the dollar bull market, as a rising dollar drains liquidity from EM and hurts fixed income instruments in these countries. On the other hand, domestic factors provide a tailwind for the NZD as strong inflationary pressures are emerging in the kiwi economy and New Zealand continues to be the star performer amongst its commodity peers. Overall, we are inclined to be tactically more bullish on the NZD against the AUD, as the NZD/USD has reached oversold levels, while AUD/USD has been firmer amidst the rally in the U.S. dollar. Report Links: Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Risks To The Cyclical Dollar View - February 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Following up from last week's depreciation is an even weaker CAD this week. USD/CAD appreciated greatly amidst a large decline in oil prices after crude oil stocks increased by around 7 mn bbl more than the previous change and the consensus amount. This trend is likely to continue as rig counts continue to increase. A rising USD is likely to exacerbate the decline in the CAD as it will continue to weigh on oil prices. We have previously noted that the CAD will stay very affected by U.S. trade relations and rate differentials. This trend is likely to continue. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been encouraging: Unemployment continues to be very low at 3.3%. Headline inflation came in at 0.5%. At this level inflation now stands at its highest since 2011. Although these developments are positive, the SNB will continue to aggressively intervene in the currency and prevent further appreciation. The SNB has been keen on keeping their unofficial floor of 1.065 in EUR/CHF, even on the face of risk-off flows coming into Switzerland due to the European election cycle. In fact, the SNB reserves surged at the highest pace since December 2014, which indicates that the central bank has been having its hands full. For now the SNB will continue with this policy, however, we will continue to monitor Swiss data to assess whether a change in policy by the SNB is possible. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 USD/NOK rallied sharply following the 5% plunge in oil prices, as the rise in inventories came at almost 7 million barrels above expectations. The risk profile for the NOK is the opposite of the NZD. External factors should help the Norwegian economy vis-à-vis other commodity currencies, as oil should outperform industrial metals given that it has a lower beta to China and Emerging markets. On the other hand, the domestic situation has deteriorated. Nominal GDP is contracting, the output gap stands around -2% of potential GDP, and the credit impulse continues to be negative. Meanwhile, inflation is starting to recede, as the effect of the depreciation of the NOK on 2015 is dissipating. All of these factors should support a dovish bias from the Norges Bank, hurting the NOK going forward. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The krona will resume its cyclical downward trend as the USD continues to climb, being one of the currencies with the highest betas to the dollar. Our bullish case for the krona is weakened by the Riksbank's extremely cautious tone which, so to speak, stopped the krona in its tracks. EUR/SEK stopped its depreciation abruptly in the beginning of February and has since appreciated. Momentum, however, does seem to be slowing down for this cross as the Swedish economy remains inherently resilient. As a large proportion of Sweden's exports to the euro area are re-exported to EM, additional risks may emanate from China as any potential slowdown in the world's second largest economy could provide a risk to Sweden's industrial sector. This could add deflationary pressures to the economy, which can solidify the Riksbank's dovish stance even further. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

The Tactical Asset Allocation model can provide investment recommendations which diverge from those outlined in our regular weekly publications. The model has a much shorter investment horizon - namely, one month - and thus attempts to capture very tactical opportunities. Meanwhile, our regular recommendations have a longer expected life, anywhere from 3-months to a year (or longer). This difference explains why the recommendations between the two publications can deviate from each other from time to time. Highlights In February, the model underperformed global equities and the S&P 500 in USD and local-currency terms. For March, the model slightly increased its allocation to stocks and cut its weighting in bonds (Chart 1). Within the equity portfolio, the allocation to Europe was increased. The model boosted its weightings to French and Australian bonds at the expense of Canadian and Swedish paper. The risk index for stocks, as well as the one for bonds, deteriorated in February. Feature Performance In February, the recommended balanced portfolio gained 2.1% in local-currency terms, and 0.2% in U.S. dollar terms (Chart 2). This compares with a gain of 3% for the global equity benchmark and a 3.3% gain for the S&P 500. Given that the underlying model is structured in local-currency terms, we generally recommend that investors hedge their positions, though we provide suggestions on currency risk exposure from time to time. The high allocation to bonds continued to hold back the model's performance. Chart 1Model Weights Chart 2Portfolio Total Returns Weights The model increased its allocation to stocks from 53% to 57%, and cut its bond weighting from 47% to 43% (Table 1). Table 1Model Weights (As Of February 23, 2017) The model increased its equity allocation to Dutch and Swedish equities by 4 points each, Germany and New Zealand by 2 points each, and France and Emerging Asia by 1 point each. Weightings were cut in Italy by 4 points, Latin America by 3 points, Spain by 2 points, and Switzerland by 1 point. In the fixed-income space, the allocation to Australia was boosted by 8 points, France by 6 points, and Germany by 4 points. The model cut its exposure to Swedish bonds by 9 points, Canadian bonds by 6 points, U.S. and U.K. bonds by 3 points each, and Kiwi bonds by 1 point. Currency Allocation Local currency-based indicators drive the construction of our model. As such, the performance of the model's portfolio should be compared with the local-currency global equity benchmark. The decision to hedge currency exposure should be made at the client's discretion, though from time to time, we do provide our recommendations. The most recent bout of dollar depreciation was halted in February. Our Dollar Capitulation Index is below neutral levels. However, it is not extended, meaning that it does not preclude renewed dollar weakness in the near term. That said, assuming no major negative economic surprises, a relatively more hawkish Fed versus its peers should provide support for the dollar (Chart 3). Chart 3U.S. Trade-Weighted Dollar* And Capitulation Capital Market Indicators The risk index for commodities was little changed in February. The model continues to avoid this asset class (Chart 4). The risk index for global equities rose to its highest level since early 2010, mostly on the back of deteriorating value. Despite this, the model slightly increased its allocation to equities (Chart 5). Chart 4Commodity Index And Risk Chart 5Global Stock Market And Risk The rally in U.S. stocks - driven by optimism about the economic outlook - pushed the value component of the risk index into expensive territory. The model kept a small allocation in U.S. equities. A change in the perception about the ability of the new U.S. administration to boost growth remains a risk for this market (Chart 6). The risk index for euro area equities continues to deteriorate. However, it remains lower than its U.S. counterpart. The continued flow of solid economic data and a weaker currency should bode well for euro area stocks, although political uncertainty is a potential headwind (Chart 7). Chart 6U.S. Stock Market And Risk Chart 7Euro Area Stock Market And Risk All three components of the risk index for Dutch equities are close to neutral levels. As a result, despite the recent deterioration in the overall risk index, it remains one of the lowest among the markets the model covers (Chart 8). The risk index for Swedish stocks worsened. However, the model increased its allocation to this bourse. Swedish equities would be a beneficiary of the continued risk-on environment (Chart 9). Chart 8Netherlands Stock Market And Risk Chart 9Swedish Stock Market And Risk The momentum indicator for global bonds is less stretched in February. Meanwhile, despite its latest decline, the cyclical indicator continues to signal that the positive global economic backdrop is firmly bond-bearish. Taken all together, the risk index for bonds deteriorated in February, although it still remains in the low-risk zone (Chart 10). U.S. Treasury yields moved sideways in February as investors await more guidance from the Fed on the timing of the next hike. A bond-negative cyclical indicator coupled with the unwinding of oversold conditions - as per the momentum measure - led to a deterioration in the risk index for U.S. Treasurys. The latter is almost back to neutral levels. The model trimmed the allocation to this asset class (Chart 11). Chart 10Global Bond Yields And Risk Chart 11U.S. Bond Yields And Risk The momentum indicator remains the main driver of the risk index for Canadian bonds. As a result, the less extreme momentum reading translated into an increase in the risk index for this asset class. (Chart 12). The risk index for Australian bonds moved lower in February, reflecting improvements in all three of its components. The model included the relatively high-yielding Aussie bonds in the portfolio. (Chart 13). Chart 12Canadian Bond Yields And Risk Chart 13Australian Bond Yields And Risk The cyclical indicator for euro area bonds is near expensive levels, and the momentum indicator shows heavily oversold conditions. These two measures are offsetting the cyclical one that is sending a bond-bearish message. While the overall risk index for euro area bonds is in the low-risk zone, the country allocation is concentrated in French paper (Chart 14). The risk level for French bonds is seen as low thanks to oversold momentum. French presidential elections are probably the most important political event in Europe this year. Whether the models' heavy allocation to this asset pans out hinges to a certain extent on the reduction of investor anxiety about this political risk (Chart 15). Chart 14Euro Area Bond Yields And Risk Chart 15French Bond Yields And Risk The 13-week momentum measure for the dollar broke below the zero line, and is currently sitting on its upward-sloping trendline, drawn from the 2010 lows, that has been broken only once before. Meanwhile, the 40-week rate of change measure is still suggesting that the dollar bull market has more legs on a cyclical horizon. Monetary divergences should lend support to the dollar over the cyclical horizon, although the new administration's attempts to talk down the dollar as well as heightened policy uncertainty could translate into more volatility (Chart 16). The weakening trend in the yen hit a snag two months ago, as the 13-week momentum measure reached the lows that previously foreshadowed a consolidation phase after sharp depreciations. This short-term rate-of-change measure has bounced smartly this year reaching a critical level. Meanwhile, the 40-week rate-of-change measure is not warning of a major change in the underlying trend which remains dictated by BoJ's dovish bias (Chart 17). EUR/USD has been gravitating towards 1.05 over the course of February. The short-term rate-of-change measure seems to be holding at the neutral level, while the 40-week rate-of-change measure is in negative territory, but hardly stretched. Political uncertainty has the potential to drive the euro in near term, but the longer-term outlook is mostly a function of the monetary policy divergence between the ECB and the Fed (Chart 18). Chart 16U.S. Trade-Weighted Dollar* Chart 17Yen Chart 18Euro Miroslav Aradski, Senior Analyst miroslava@bcaresearch.com

Highlights The Fed & Yields: Positive U.S. growth and inflation momentum is maintaining the credibility of the Fed's 2017 rate hike plans. U.S. bond yields, in particular, and global yields, in general, will remain under upward pressure in this environment, despite the aggressive short positioning in the U.S. Treasury market. Maintain a below-benchmark portfolio duration stance. "Soft" vs. "Hard" Data: After a deep dive into the economic data for the major countries, both "hard" demand indicators and "soft" survey measures, we have little doubt that a tangible global growth acceleration is underway. This positive economic backdrop will continue to put upward pressure on government bond yields while boosting the relative return performance for corporate credit. Australia: The cyclical outlook Down Under has become murkier of late, even with the RBA starting to shift in a more hawkish direction. We are taking profits on our recommended pro-growth tilts in Australia. Feature The positive momentum on global growth continues to put upward pressure on bond yields, despite the large short positioning already in place in the government bond markets. The benchmark 10-year U.S. Treasury yield returned to 2.5% at one point last week, led by a rash of better-than-expected data on U.S. retail sales and inflation, combined with hawkish comments from numerous Fed officials (Chart of the Week). Markets started to more seriously consider a March Fed rate hike, although we still see June as the more likely date for the Fed's next tightening move. As we have discussed in several recent reports, it is a surge in global economic survey data that suggests that a broad-based upturn currently underway. While this is all good news for risk assets, there is some concern among investors that a pick-up in growth has been slow to appear clearly in the "hard" economic data related to final demand. Without a boost in actual economic activity, and not just "feel good" surveys, the pro-growth momentum currently embedded in equity and bond markets may melt away as rapidly as it was built up. Mark McClellan, the Chief Strategist at BCA's flagship publication, The Bank Credit Analyst, is releasing a report this week that digs into the differences between "soft data" (i.e. surveys) and "hard data" (i.e. employment and production).1 We present some excerpts from that report in the following section. Global Growth Pickup: Fact Or Fiction? Investors have taken some comfort from the fact that leading indicators are trending up across most of the developed and emerging economies. BCA's Global Leading Economic Indicator is moving higher and will climb further in the coming months given that its diffusion index is well above 50 (Chart 2). The Global ZEW indicator and the BCA Boom/Bust growth indicator are also constructive on the growth outlook. Chart of the WeekNo Bond-Bearish Data In The U.S. Chart 2A Consistent, Positive Message On Growth Consumers and business leaders are feeling more upbeat as well, both inside and outside of the U.S. (Chart 3). Importantly, the improvement in sentiment began before the U.S. election. Surveys of business activity, such as the Purchasing Managers Indices (PMI), are painting a uniformly positive picture for near-term global output in both the manufacturing and service industries. While this is all good news for risk assets, there is concern that a growth impulse has been slow to show up clearly in the "hard" economic data related to final demand. The good news is that there is more to the cyclical upturn than hope. The improved tone in the forward-looking data is now clearly showing up in some measures of final demand. The caveat is that there is no evidence yet that the cyclical mini up-cycle in 2017 is any less vulnerable to negative shocks than was the case in previous upturns since the Great Recession. The Hard Data First, we start with some bad news. There has been a worrying loss of momentum in job creation in recent months (Chart 4). While employment gains have accelerated in Japan, Canada and Australia, the payroll slowdown is mainly evident in the U.S. and U.K. This may reflect supply constraints as both economies are near full employment, but it is difficult to determine whether it is supply or demand-related. The good news is that the employment component of the global PMI has rebounded sharply following last year's dip, suggesting that the pace of job creation will soon turn up. Chart 3Surging Confidence, Production Following Suit Chart 4Global Employment Growth Cooling Off Also on the positive side, households are opening their wallets a little wider according to the retail sales data (Chart 5), where growth has accelerated sharply in all the major economies except U.K. and Australia (NOTE: we discuss the Australian bond outlook later in this Global Fixed Income Strategy report). Similarly, business capital spending is finally showing some signs of life following a rocky 2015 and early 2016. An aggregate of Japanese, German and U.S. capital goods orders2 is a good leading indicator for G7 real business investment (Chart 6). The acceleration of imported capital goods for our 20-country global aggregate corroborates the stronger new orders reports (bottom panel). Chart 5On Your Mark, Get Set, Shop!! Chart 6Global Capex Cycle Turning Positive Recent data on industrial production show that the global manufacturing sector is clearly emerging from last year's recession. Short-term momentum in production growth has accelerated over the past 3-4 months across all of the major advanced economies (Chart 7). Production growth has been particularly robust in the Eurozone, U.K. and Japan. Industrial output related to both household and capital goods is showing increasing signs of vigor in recent months (Chart 8). Chart 7A Global Manufacturing Upturn Chart 8A Broad-Based Acceleration At the moment, the upturn in manufacturing production is being driven by a broader pickup in business spending. The acceleration in production and orders related to consumer goods in the major countries suggests that household final demand is also showing increased vitality, consistent with the retail sales data. The Soft Data Chart 9Global GDP Growth Is Accelerating Notwithstanding the nascent upturn in the hard data, some believe that the soft data are sending an overly constructive signal in terms of near-term growth. The soft data generally comprise measures of confidence and surveys of business activity. One could discount the pop in U.S. sentiment as simply reflecting hope that President Trump's election promises to cut taxes, remove red tape and boost infrastructure spending will come to fruition. Nonetheless, improved sentiment readings are widespread across the major countries, which means that it is probably not just a "Trump" effect. Moreover, there is no reason to doubt the surveys of actual business activity. Surveys such as the PMIs, the U.K. CBI Business Survey, the German IFO current conditions index and the Japanese Tankan survey are all measures of activity occurring today or in the immediate future (i.e. 3 months). There is no reason to believe that these surveys have been contaminated by "hope" and are sending a false signal on actual spending. To test the reliability of the growth message from the "soft data", we employed these indicators in regression models for real GDP in the four major advanced economies and for the G7 as a group (Chart 9). The models predict that G7 real GDP growth will accelerate to 2½% on a year-over-year basis in the first quarter of 2017. We expect growth of close to 3% in the U.S. and a little over 2½% in the Eurozone, although the model for the latter has been over-predicting somewhat over the past year. Japanese growth should accelerate to about 2% in the first quarter based on these indicators. The implication is that the survey data are not sending a distorted message; underlying growth is accelerating even though it is only now showing up in the hard economic data. Turning for a moment to the emerging world, output is picking up on the back of an upturn in exports. However, we do not see much evidence of a domestic demand dynamic that will help to drive global growth this year. The main exception is China, where private sector capital spending growth has clearly bottomed. Stronger Chinese capital spending in 2017 will boost imports and thereby support activity in China's trading partners, particularly in Asia. Conclusions We have little doubt that a meaningful global growth acceleration is underway. Our sense is that 'animal spirits' are finally beginning to stir, following many years of caution and retrenchment. American CEOs appear to have more swagger these days. Since the start of the year there have been a slew of high-profile announcements of fresh capital spending and hiring plans from companies such as Amazon, Toyota, Walmart, GM, Lockheed Martin and Kroger. A return of animal spirits could prolong a period of stronger growth, even if President Trump's growth-boosting policies are delayed or largely offset by spending cuts or trade wars. This economic backdrop is positive for risk assets and bearish for government bonds. Bottom Line: After a deep dive into the economic data for the major countries, both "hard" demand indicators and "soft" survey measures, we have little doubt that a tangible global growth acceleration is underway. This positive economic backdrop will continue to put upward pressure on government bond yields while boosting the relative return performance for corporate credit. Australia: The Equation Gets More Complicated Two weeks ago, the Reserve Bank of Australia (RBA) unsurprisingly left its cash rate unchanged at 1.5%. The post-meeting statement by RBA Governor Philip Lowe was considered hawkish by economic analysts. Nonetheless, the market reaction has been relatively muted, with the Australian government bond yield curve steepening by only 5 bps, and the Aussie dollar remaining stable, since the meeting. Pricing in the OIS curve suggests that the RBA will probably remain on hold throughout 2017, but the implied odds of a rate hike are rising, standing now at 20%. The RBA's assessment of the current global economic backdrop was relatively constructive, pointing to above-trend growth expectations in a number of advanced economies. Domestically, the RBA foresees a boost to Australian export growth from the resource sector, an end to the decline in mining investment and a pick-up in non-mining capital spending.3 With such a tone, the central bank might have set up the market for some disappointments. The new forecast of economic growth around 3% for the next couple of years seems overly optimistic. This is higher than the median expectation of economists surveyed by Bloomberg, who foresee 2.5% and 2.8% growth for 2017 and 2018, respectively. The IMF does not expect growth to reach 3% until 2019. Granted, several parts of the economy have shown very robust performances of late. The service sector PMI has surged to pre-crisis levels. The NAB survey of business conditions also shot higher last week. Goods exports have exploded at a 40% annual growth rate, causing the December trade balance to jump to $3.5bn, nearly double the consensus $2.0bn estimate (Chart 10). Those jumps in activity are hard to ignore. From a big picture perspective, however, Australian economic data has not been surprising to the upside, unlike the trend in in the rest of the world over the past few months (Chart 11). This is intriguing, since an easy monetary policy, loose bank credit conditions, improving profit expectations and a reflationary impulse coming from China were all tailwinds that should have supported Australian growth; this was our view last year.4 Now, those favorable factors have started to reverse, raising the chances of a cyclical economic downturn. Chart 10Surging Numbers Chart 11Surprisingly Unsurprising Foremost, overall labor market conditions are uninspiring (Chart 12): Although the monthly employment change for January did positively surprise, at 13.3k versus an expected 10k, the pace of job creation remains under 1% year-over-year, which is low by historical standards. The diverging trend between plunging full-time and steady part-time job growth indicates a sub-optimal labor market. The labor force participation rate declined from 65.2 to 64.6 in 2016, suggesting an increasing amount of discouraged workers. Underemployment has not budged in the last two years and is stuck at historically high levels. As result, a rise in labor market slack poses a risk for the Australian consumer; wage growth has already been in a downtrend since 2011 (Chart 12, bottom panel). The construction sector further confirms our apprehensions on the true strength of the economy. Households believe that it is not a good time to buy a home, while building approvals for new dwelling units fell from bubbly levels at the end of last year. At the same time, speculative money, which was supposed to have been curbed by macroprudential policy measures, has returned to the housing market (Chart 13). Lower supply and increased speculation could push residential prices even higher, inflating debt burdens, and leaving households with fewer dollars to consume. Chart 12Consumption: Set To Deteriorate Chart 13The Foundations Are Shaking Externally, the Chinese reflationary mini-boom - which boosted the prices of iron ore and other commodities exported by Australia last year - will probably retreat to some extent in 2017. Although China's overall cyclical momentum remains solid, according to our GFIS China Checklist,5 government spending growth has severely relapsed, potentially signaling an end to last year's largesse (Chart 14). With that in mind, it has become difficult to envision a continuation of the positive effects from the terms of trade shock experienced by Australia in 2016. In a similar vein, but domestically-driven, Australia's credit growth has become a headwind. Between 2013 and 2015, business credit growth was expanding, creating a positive impulse for the economy. Unfortunately, this trend changed tack in 2016, with slowing credit growth now representing a negative economic force (Chart 15). With Australian banks having suffered declining profits and rising bad debt charges in the last few quarters, credit conditions could tighten going forward. This is especially worrisome since personal credit was already contracting in 2016. Chart 14China Mini-Boom Could Be Over Chart 15Negative Credit Impulse top of all this, the IMF is projecting that Australia's fiscal thrust - the change in the primary government budget balance - will be negative in each of the next five years (Chart 16). As such, this economy could run out of supporting impulses in the short to medium term. Summing it all up, we agree with the current market pricing of interest rates, given the economic uncertainties. The RBA will most likely remain on hold for the foreseeable future. The story remains the same; the central bank wants to depreciate the overvalued Aussie dollar, but excesses in the housing market prevent them from weakening the currency through interest rate cuts (Chart 17). Now, the declining cyclical outlook will only complicate the equation. Chart 16Negative Fiscal Impulse Chart 17The RBA Has Little Room To Maneuver Investment Implications Our updated and more balanced economic view of Australia leads us to neutralize our recommended pro-growth Australia bond tilts: Asset allocation. As discussed above, the previously favorable factors supporting the Australian economy are progressively reversing. This is not the case in most of the other bond markets where additional cyclical upward pressure on global yields is anticipated. To reflect this view, today we are upgrading our recommended Australian bond exposure to neutral, from below-benchmark, within global hedged bond portfolios. This underweight position produced +188bps of excess return versus the global benchmark since inception in June 2016. Duration. The 10-year Australian government bond yield, 1-year forward, is 3.04%, 25bps above the current yield of 2.79%. There is a good chance that yields will rise at a faster pace than implied by the forwards at times over the course of the year, given the improving global growth and inflation backdrop. However, these instances will be opportunities to extend duration within dedicated Australian fixed income portfolios. Current Australian government bond valuation has become very cheap and is now at a level that has been associated with the beginning of positive absolute performance in the past. Moreover, the 10-year inflation breakeven is already pricing in a fair amount of inflation increases; those expectations will be hard to surpass, especially considering the low starting point (Chart 18). Curve. In May 2016, we initiated an Australian butterfly curve trade, going long the 2-year/6-year barbell versus the 4-year bullet. At the time, the 2/4/6 part of the government bond yield curve was kinked, with the 4-year sector trading very expensive versus the 2-year and 6-year maturities, reflecting the perception of a dovish stance by the RBA. then, the market has priced out these rate cut expectations, as we expected, and this part of the curve has bear steepened (Chart 19). Today, we close this trade at a +36bps profit. The RBA's future potential actions - or, more likely, inaction - are now properly discounted in the curve and reflect our neutral stance on the RBA. Chart 18Time To Buy Australian Bonds Chart 19Taking Profits On Our 2/4/6 Butterfly Trade Credit trades. Developing economic uncertainties warrant more cautiousness towards Australian credit. In March 2016, we recommended going long Australian semi government debt versus federal government bonds as an initial way to play what was, at the time, a relatively constructive view on the Australian economy.6 Now, given the increased economic risks, we are closing this relative value trade with a +133bps profit. Mark McClellan, Senior Vice President markm@bcaresearch.com Jean-Laurent Gagnon, Editor/Strategist jeang@bcaresearch.com Robert Robis, Senior Vice President rrobis@bcaresearch.com 1 Please see The Bank Credit Analyst, Section II, "Global Growth Pickup: Fact Or Fiction?," dated March 2017, available at bca.bcaresearch.com 2 Machinery orders used for Japan 3 http://www.rba.gov.au/media-releases/2017/mr-17-02.html 4 For details, please see BCA Global Fixed Income Strategy Weekly Report, "Last Minute Recommendations Before The Brexit Vote," dated June 21, 2016, available at gfis.bcaresearch.com 5 For details concerning this indicator, please see BCA Global Fixed Income Strategy Weekly Report, "How To Assess The "China Factor" For Global Bonds," dated November 11, 2016, available at gfis.bcaresearch.com 6 Please see BCA Global Fixed Income Strategy Special Report, "Australian Credit: Time To Test The Waters," dated March 29, 2016, available at gfis.bcaresearch.com The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Feature The FX Market has a strange way of proving everyone wrong. Currently, we are finding ourselves uncomfortable with our cyclically bullish stance on the dollar as it has become a consensus view. A review of the rationale and risks to our view is in order. To begin with, let's review valuations. The dollar is overvalued by 8% at the current juncture. However, this overvaluation is still much more limited than the overvaluation of 22% registered in 1985 and of 17.7% recorded in 2002 (Chart I-1). Chart I-1Dollar Is Not Cheap, Yet It Can Get More Expensive This has two implications. First, we have always considered valuations as the ultimate measure of sentiment. After all, it is a reflection of how much people are willing to pay for an asset or currency, and therefore, how optimistically they view the prospects for that asset/currency. The USD's overvaluation being limited compared to previous instances suggests that investors' love affair with the greenback has yet to reach the exuberant heights reached in 1985 and 2002. In fact, at this point in time, the U.S. basic balance has improved considerably, especially vis-à-vis the euro area (Chart I-2). This suggests that investors are finding more attractive investments in the U.S. than in the euro area, and that so far, the strong dollar has not had a deleterious enough effect to hurt the perceived long-term earning power of the U.S. This can continue to weigh on EUR/USD, lifting DXY in the process. Second, the dollar has yet to represent the same drag on the U.S. economy that it did at its previous peaks. It is true that U.S. potential GDP growth is now lower than previously, dragged down by both lower labor force growth and lower trend productivity growth. However, manufacturing represents a much smaller share of employment than in these two instances, suggesting that the labor market should prove more robust in the face of the strong USD (Chart I-3). Chart I-2Basic Balance Dynamics Have ##br##Favored The USD Until Now Chart I-3The U.S. Dwindling ##br##Manufacturing Employment Thus, we continue to expect that the ongoing labor market tightening can run further. With the amount of slack in that market having now vanished, we are disposed to expect a quickening in wage growth in the coming quarters (Chart I-4). Additionally, we expect the U.S. labor market to promote a virtuous circle for the economy. As the job market tightens, wages and salary as a share of the economy rise. This skews the income distribution away from the top 1% of households - families who derive more than 50% of their incomes from profits, rents, and proprietors' incomes - toward the middle class. This redistribution effect should support consumption: middle class and poor households have marginal propensities to spend ranging between 90% and 100% while rich families have a marginal propensity to spend of around 60% Not only does household consumption represent nearly 70% of the U.S. economy, but also 70% of this consumption goes toward services. Services are principally domestically sourced and are a sector of the economy where productivity is hard to come by. As a result, we expect the boost in household consumption to be a key mechanism that will support employment and wage growth. Additionally, the strength of wages and salaries as a share of gross national income, coupled with the high degree of consumer confidence, could be a harbinger of a revival in capex. Historically, when these two measures of household health are behaving as they currently do, investment in the economy increases (Chart I-5). A few factors can explain this relationship: First, this strength in households boosts residential investment; Second, it also gives confidence to the business sector that final domestic demand is durable, a key factor boosting domestic producers willingness to invest; Third, the boost to residential investment lifts investment in the sectors of the economy linked to consumer durable goods. Moreover, the stabilization of U.S. profits, along with the narrowing of U.S. corporate spreads have boosted the capex intentions of businesses, a move that began even before Trump won the election. This has historically been a reliable leading indicator of both capex and the overall business cycle (Chart I-5). Chart I-4A Tight Labor Market ##br##Will Support Households... Chart I-5...And Households Support ##br##Domestic Businesses With U.S. trend GDP growth having fallen, lower growth is needed than in prior cycles to absorb the slack in the economy. In fact, our composite capacity utilization gauge currently shows an absence of slack (Chart I-6). Any further acceleration of growth would move the economy into "no slack" territory, an environment that has historically coincided with protracted Fed tightening campaigns. Chart I-6If The Fed Doesn't Heed The Message From Capacity Utilization, The Dollar Will Weaken However, if the Fed does let capacity move much above its constraint and does not react as much as it ought to, the inflationary outcome created by such a move would be devastating for the dollar: Rapidly rising U.S. price levels would hamper the USD's long-term PPP fair value; The process would also result in falling U.S. real yields, especially vis-à-vis nations with more signs of excess capacity, like the euro area, pushing down the greenback from a real interest-rate parity perspective; The easy Fed policy would ease global liquidity conditions, creating a shot in the arm for the global economy and EM in particular. Historically, an accelerating global economy hurts the dollar. We remain with the view that the Fed is unlikely to let such an outcome materialize. Yellen has gone out of her way to highlight that generating a "high-pressure" economy in the U.S. was a dangerous outcome that the FOMC wanted to avoid. In fact, the potential for Trump's fiscal stimulus, whenever it may be enacted, only raises the likelihood that the Fed leans against the inflationary under-current created by dissipating economic slack. The second risk to the dollar is the growing talk of a new Plaza Accord in the U.S. At this point, with Trump attacking China, the EU, and in fact, most trading partners, we think that the likelihood of moral suasion achieving its goal is low. However, we want to study this topic in more detail before coming to definitive conclusion. So where does this leave us with regard to our original discomfort with standing in the middle of the crowd? We continue to expect the dollar cycle to expand. However, we expect that the correction that begun after the December Fed meeting could run further before exhausting itself. This would be the key mechanism through which the stale longs that are accumulating will get shaken off. In fact, the current push-back against Trump by the political establishment, from both the republicans and the bureaucratic apparatus could raise doubts on Trump's ultimate capacity to achieve his fiscal policy goals. While we expect that these doubts will stay just that, doubts, and that Trump will ultimately make stimulus into law, this period of questioning could be enough to hurt a dollar still too loved by investors. Bottom Line: We are finding ourselves in the middle of the consensus with our cyclical dollar-bullish stance. However, U.S. economic fundamentals are still firmly bullish for the dollar and valuations are not yet potent enough to prompt the end of the dollar bull market. Short AUD/NZD After a long hiatus, inflation is making a comeback in New Zealand. Last week, inflation numbers for Q4 came in at 1.3%, marking the first time since 2014 that it exceeded 1%. This has significant implications for the RBNZ, given that persistently low inflation was the shackle that kept its dovish bias in place. As inflation starts to creep up, this should put upward pressure in rates and lift the NZD. Chart I-7Domestic Factor Points Will Help ##br##The Kiwi Outperform The Aussie Nevertheless, we are reticent to buy NZD/USD outright, as the dollar bull market should continue to weigh on the kiwi as well as on other commodity currencies. Instead we are expressing our view by shorting AUD/NZD. The outlook for these Oceanian countries could not be more different. New Zealand has been the best performing economy in the G10 with real GDP rising by 3.5% and employment growing at a staggering 6% pace, the highest level of the last 23 years. Meanwhile, Australia's real GDP growth has slowed down to 1.7% while employment growth is currently in negative territory. This contrast in economic performance is likely to dramatically increase inflationary pressures in New Zealand relatively to Australia, particularly if one considers that New Zealand's economy is growing at 2% above potential GDP while Australia's output gap is far from closed. Furthermore, growing divergences in housing and stock prices are also pointing to a widening in rate differentials (Chart I-7). These factors along with inflation should push kiwi rates up vis-à-vis Australian rates, and consequently weigh on AUD/NZD. The outlook for New Zealand's and Australia's main commodities (dairy products and iron ore respectively) also points to further downside in this cross. As previously highlighted, a weakening Chinese industrial sector and a tightening of global dollar liquidity should translate to an underperformance of base metals in the commodity space, given that China consumes roughly half of the world's industrial metals and that these commodities are highly sensitive to EM liquidity conditions. Meanwhile, although China is also the main consumer of dairy products, prices should hold up thanks to the recent loosening in the "One child" policy, which should increase demand for baby formula.1 This view is not without risks. The all-time low for AUD/NZD of 1.02 is not that far away, and could likely provide significant support to this cross. Indeed, one could argue that much of the widening in rate differentials is probably already priced in the cross. However, the difference in overnight rates between the central banks of these countries is a measly 25 basis points (with roughly another 25 basis points priced by the market until the end of 2017). Given the stark difference between the outlooks for these two economies we believe further widening could be warranted. Moreover, while it is true that the recent disappointment in kiwi unemployment numbers might provide fuel for the doves in the RBNZ for a bit longer, the markets have already reacted accordingly, with AUD/NZD rallying sharply since. Thus, we think that this recent rally provides a good entry point to short this cross. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Juan Manuel Correa, Research Assistant juanc@bcaresearch.com 1 Please see Commodity & Energy Strategy Weekly Report "The OPEC Debate", dated November 24, 2016, available at ces.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The FOMC held the federal funds rate at 0.75%, as expected. The Committee highlighted that the economy is growing "at a moderate pace", also as expected. The labor market, consumer and business sentiment, and household spending all are improving. It is also expected that this trend continues and eventually leads to their 2% inflation target. Unlike the other G10 central banks, the FOMC sees near-term risks to the economic outlook as "roughly balanced", which may warrant a greenlight for their planned hikes. ISM Prices Paid, Manufacturing PMI, and the change in employment all beat expectations, confirming the economy's healthy path. The dollar will likely display limited movements, according to both seasonality and the economy developing as expected, and will likely remain relatively weak, in wait of fiscal policy information. Report Links: Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism - January 27, 2017 U.S. Border Adjustment Tax: A Potential Monster Issue For 2017 - January 20, 2017 Update On A Tumultuous Year - January 6, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Economic activity within the common market this week was mixed, however the overall euro area is accelerating: Confidence indicators (consumer, services, overall economic, and industrial) beat expectations across the board; Annual GDP growth outperformed at 1.8%; Unemployment came at better than expected at 9.6%; Most importantly, inflation was recorded at 1.8% - more or less in line with the ECB target. Nevertheless, core inflation remains at 0.9%, which is corroborated by the mixed performance of the major euro states - Germany, in particular, performed relatively poorly. The European Commission upgraded their forecasts for GDP, unemployment and inflation, however, highlighted that risks can emanate from emerging markets and the U.S, affecting financial markets and global trade. Report Links: GBP: Dismal Expectations - January 13, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data continues to show indications of a recovery in the Japanese economy: The jobs/applicants ratio beat expectations, and now stands at 1.43 The contraction in spending seems to be receding, with overall household spending falling by 0.3% vs a 1.5% contraction in November. December industrial production also outperformed expectations, growing by 0.5%. In their latest monetary policy report the BoJ took into account the good economic data that we have been highlighting as they have raised their forecast in GDP growth going forward. This should not be taken as a sign that the BoJ is starting to back off from its radical policies, as they project that inflation will reach 2% in 2018 (the target, as we have mentioned before lies above this level). Thus, the cyclical outlook for the yen remains bearish. Report Links: Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism - January 27, 2017 Update On A Tumultuous Year - January 6, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 In their monetary policy meeting yesterday, the BoE decided to keep their policy rate unchanged. While it is true that they raised their inflation forecast for the short term, they also decreased their forecast for inflation for the long term compared to their last meeting. More importantly they adjusted their equilibrium unemployment rate to 4.5% from 5%, a development which makes the BoE more dovish than otherwise. Markets have taken notice of this, as the pound has depreciated against all major currencies. Despite this development we continue to have a bullish bias towards the pound, as we still believe that both the BoE and the market are overestimating the negative effects that Brexit can have on the British economy. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Just as the dollar began to correct, AUD displayed an upbeat performance, appreciating 6.75% since then. The weak dollar has helped commodity prices rally, iron and copper prices have appreciated in anticipation of U.S. infrastructure spending, Chinese Manufacturing PMI beat expectations, and the trade balance also outperformed expectations. While it is possible that a weak dollar can help alleviate much of the pressure off AUD, we remain obstinate on the fundamental weakness of the AUD. The Australian economy is still haunted by the mining industry slump, with the labor market feeling much of the pain. As mentioned before, a longer-term bull market in the dollar, and Trump's expected policies, can have very adverse effects on EM, global growth, global trade, and thus commodity currencies. AUD is also approaching overbought RSI-levels, as well as an important resistance level, and is likely to see some downside soon. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 On Tuesday unemployment came in at 5.2%, significantly above the market expectation of 4.8%. This caused the NZD to fall off, particularly against its crosses. However we believe that the bullish story for the NZD is still intact. Immigration continues to increase, with visitor arrivals increasing by 11% YoY. This should continue to add fuel to the stellar kiwi economy. On the commodity side, in spite of a slowdown, dairy prices continue to grow at an astonishing 47% YoY pace. Moreover the relative robustness of dairy prices to EM liquidity conditions should help the NZD outperform the AUD, as base metals are more likely to bear the brunt of a shortage in EM liquidity triggered by a rising dollar. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 On Tuesday, USD/CAD fell below 1.30 for the first time since September, breaking through an important trend line, displaying newfound strength on the back of a weak greenback. As the USD continues its corrective phase, the strong CAD could hurt Canadian exports in the near future. Canada's exports represent 25% of its GDP, and 77% of its exports are to the U.S. An implementation of the Border-Adjustment Tax could have adverse consequences for this export-oriented economy. Although this tax will likely be bullish for the greenback, Trump has emphasized his view on the excessively strong dollar. The recent GDP monthly figure of 0.4% beat consensus due to the improving domestic economy. However, the aforementioned points can be a very real threat to this improvement, and should be monitored closely. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 After falling to an 18-month low, below 1.065, EUR/CHF has once again rallied and is now close to reaching 1.07. This is the third time that our recommendation of buying this cross whenever it falls below the crucial 1.07 level proves successful. We continue to reiterate that whenever EUR/CHF approaches this level, the SBN will not be shy to intervene, as a strong franc would accentuate the deflationary pressures that plague the Swiss economy. Recent data has been disappointing, and one should expect that the SNB will be more overzealous in its management of the franc: The KOF leading indicator stood at 101.7, falling from the previous month and underperforming expectations. SVME Manufacturing PMI also fell short of expectations and fell relative to November. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 This week, the Norwegian Krone built on its stellar 2017 rally. Indeed, USD/NOK has fallen by almost 5% since the start of the year. This rally in the krone has been particularly surprising, as it has happened in an environment where oil prices have stayed relatively flat. Thus, If OPEC cuts start to cause significant inventory drawdowns, the NOK could rally much further. Additionally it is worth reminding that Norwegian inflation is a unique case in the G10, as it is the only country which has an inflation level above their central bank target. A breaking point will eventually come, where the Norges Bank will have to choose between backing off their dovish bias and letting inflation run amok. Thus, we will continue to monitor inflation in Norway closely. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Sweden's economy continues to show strength. Producer prices increased at a 6.5% yearly pace, and a 2.1% monthly pace; Consumer confidence increased to 104.6 from last month's 103.2; Manufacturing PMI increased to 62; The monthly trade balance is positive for the first time since August. The data paints a positive picture of the economy: improving inflation, high consumer confidence, and a healthy industrial and export sector. Sweden's future for its exports seems hopeful on the back of an increasing manufacturing PMI and the lagged effects of a weak SEK. Additionally, Sweden is unlikely to be majorly affected by U.S. protectionism. Exports to the U.S. only account for 2% of GDP, and 7.7% of overall exports, whereas exports to the euro area account for 11% of GDP and 40.6% of exports. The risk of a strong SEK will be limited as the Riksbank monitors its pace of strength, and the USD will eventually resume its appreciation. Report Links: Outlook: 2017's Greatest Hits -December 16, 2016 One Trade To Rule Them All - November 18, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights The U.S. growth outlook has improved but markets already reflect this reality. The U.S. dollar is losing momentum despite healthy economic releases, highlighting the risk of a pullback. EUR and JPY should be the prime beneficiaries of a dollar correction as commodity currencies are exposed to brewing Chinese risks. Short CAD/NOK and AUD/JPY. Happy New Year! Feature A defensive posturing seems increasingly appropriate for currency investors in the coming months. While we continue to expect U.S. growth to strengthen toward 3% this year, asset prices have already discounted a very positive economic outcome. As Chart I-1 illustrates, the ratio of metal to bond prices (adjusted for relative return volatilities) tends to be a good leading indicator of U.S. growth. However, this indicator clearly shows that investors are already positioned for solid growth. Chart I-1The Economic Outlook Has Improved, But Markets Are Aware Moreover, bond prices have uniformly discounted good news. Both our composite sentiment indicator and the bonds' fractal dimension - a measure of groupthink - highlight that investors are collectively positioned for a bearish Treasury outcome (Chart I-2). This raises the risk that even a good growth number out of the U.S. will disappoint investors. Lofty expectations are not confined to bonds and metals, however. DXY and the broad trade-weighted dollar are also displaying some groupthink, another troubling sign for dollar bulls like us (Chart I-3), who find our side of the ledger increasingly crowded. Chart I-2Buying Bonds Is A Contrarian Play Chart I-3Dollar Could Pull Back What does this all mean? In our 2017 outlook, we mentioned that while the risk of a dollar correction was rising, the dollar's momentum was too strong to fight at this point in time.1 Moreover, historically, January tends to be a strong month for the dollar (Chart I-4). A window of opportunity to get short may be opening up. For one, the dollar has been losing momentum in the past few weeks, shown by the divergence that is emerging between prices and momentum (Chart I-5). Additionally, net speculative positions on the dollar are near record highs but, more importantly, are not making new highs (Chart I-6). Chart I-4The Greenback Likes The New Year Chart I-5Dollar Momentum Is Weakening Chart I-6Long Dollar: A Crowded Trade Interestingly, the Swedish krona, the currency with the most negative beta to the dollar is now showing surprising signs of strength (Chart I-7). This is particularly remarkable as this week the Riksbank announced it would pursue currency-market interventions if it judges that a strong currency threatens its inflation target. Hence, if the krona's underperformance was a harbinger of dollar strength this past fall, the SEK's current resilience may foreshadow a correction in the greenback. In terms of the dollar's reaction to recent economic data, the greenback has been unable to rally on strong fundamentals this week. Instead, the dollar softened despite healthy readings from the ISM manufacturing survey, with the headline measure rising to 54.7 and the new orders component surging to 60.2. Relatively hawkish FOMC minutes couldn't even support DXY. In fact, European PMIs seem to have overshadowed U.S. economic data. The European Manufacturing PMI is at a six year high (Chart I-8). Even the French consumer is feeling perky, with the consumer confidence hitting a nine year high. Chart I-7SEK Upside Equals USD Downside Chart I-8Good Numbers In Europe The absence of U.S. dollar strength in response to strong economic news at a time of seasonal strength for the USD raises the risk of a dollar correction in the coming weeks. We expect the yen and the euro to be the prime beneficiaries of such moves. Commodity currencies, on the other hand, might be unable to take advantage of any dollar weakness. Too much good news have been priced in. Commodities have been lifted by the perception of stronger growth in the U.S., but also by the common refrain among investors that the Chinese authorities will continue to reflate the economy in the run up to the Communist Party Congress this autumn. We worry that China is likely to be a source of negative shock. Investors are increasingly likely to see their hopes of stimulus dashed, particularly since the Chinese economy does not look like it needs much stimulus right now. The Keqiang index - a comprehensive measure of industrial activity - is at post-2010 highs and real estate markets have become very frothy (Chart I-9). Moreover, the recent surge in bitcoin prices - despite a strong dollar - suggests that capital outflows out of China are intensifying despite tightening capital account restrictions (Chart I-10). Indeed, bitcoin prices started their recent ascent as talks of capital controls in China grew in late 2015. The result has been higher interest rates and a tightening of Chinese financial conditions. This also gives the authorities an impetus to let the RMB fall - representing another deflationary shock for EM economies and commodity producers. Chart I-9China Doesn't Need Reflation Chart I-10Symptoms Of Chinese Outflows In this environment, oil prices are likely to fare better than metal prices, one of the key themes we highlighted in our 2017 outlook, which should benefit our short AUD/CAD trade. In addition, we are reopening our short CAD/NOK position. CAD/NOK is trading 15% over its fair value (Chart I-11), and would benefit in the event of a USD correction. Moreover, the Canadian surprise index, which had surged relative to that of Norway has now rolled over, pointing toward weaknesses for this cross (Chart I-12). Chart I-11CAD/NOK Is Overvalued ##br##CAD/NOK Is Expensive Chart I-12Economic Momentum ##br##Moving Against CAD/NOK Another opportunity seems to be emerging in the yen. Speculators are massively short the yen and our yen capitulation index continues to hover near 22-year lows (Chart I-13). From current levels, the yen could easily move toward 110, especially if our view on the dollar and Chinese policy risks is correct. That being said, the more than 1% fall in USD/JPY yesterday suggests that investors may want a more attractive entry point. Investors should also consider shorting AUD/JPY. Not only is this cross very sensitive to movements in the yen, but it also provides a direct way to capitalize through the currency market on falling metal prices and rebounding bond prices (Chart I-14). Moreover, AUD is very sensitive to Chinese economic conditions, and tightening Chinese liquidity along with a falling RMB would do great damage to the Aussie. Chart I-13JPY Has ##br##Upside Chart I-14Short AUD/JPY Equal ##br##Short Metals / Long Bonds Bottom Line: Financial markets have priced in a lot of good news in a short amount of time. Investors are now vulnerable to a pullback in risk assets and a rebound in bond prices. This process is likely to support the European currencies and the yen against the dollar, but hurt commodity currencies. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Special Report, "Outlook: 2017's Greatest Hits", dated December 16, 2016, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The minutes from the December 14 FOMC meeting highlighted that Trump's fiscal proposal still lacks clarity, but the Fed's hawkish shift remains in place despite the tightening conditions brought about by a rising dollar. Anxiety about future growth may have resurfaced from this realization, prompting dollar bulls to close some of their bets: the DXY plunged 1.7% in just two days. Alongside this, Treasurys have rallied 1.7% and the 10-year yield has dropped 8 bps. Data from the U.S. in the past few months has been consistently positive, with this week also showing an uptick in Manufacturing PMI to 54.7 from 53.2, and prices paid increasing by 11 points to 65.5. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 Party Likes It's 1999 - November 25, 2016 One Trade To Rule Them All - November 18, 2016 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 The Euro Area ended the year on an up note, as manufacturing, service and composite PMIs all outperformed consensus and preceding figures for most of the major euro countries. The resulting effect was a pickup in CPI, as headline inflation for the Euro Area came in at 1.1% YoY, and core at 0.9%. The labor market continues to make steady progress as Germany recorded a decrease in unemployed people by 17,000, and Spain, a decrease of 86,800. It is too early to tell whether this data will affect the ECB's next monetary policy stance. However, what is evident is that EUR/USD is more likely to move on U.S. economic surprises than anything else. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 On December 20th the BoJ left rates unchanged and maintained its yield curve control program that keeps 10-year rates near 0%. In its statement, the bank admitted that it expects a moderate expansion on 2017 as Japan continues to recover. We are sympathetic to this view. With the yen and Japanese real rates falling, the economy should be able to get out of its deflationary trap. Indeed, recent data shows that things might be turning for Japan: Both Services and Manufacturing PMI increased last month and are now at 52.3 and 52.4 respectively. Retail trade growth came at 1.7% YoY, beating expectations. We maintain that the yen should see more downside on a cyclical basis, given that the BoJ will maintain their yield curve control program until inflation overshoots their 2% target. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 Party Likes It's 1999 - November 25, 2016 One Trade To Rule Them All - November 18, 2016 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 The pound has remained relatively unchanged against the dollar since the start of the year. The decision by the Supreme Court will be a key event to watch as it will determine whether the U.K. parliament has authority in determining how Britain exits from the European Union. Aside from political risks, The British Economy has remained resilient despite the uncertainty unleashed by last year's referendum. Recent data confirms this: Markit Manufacturing PMI came in at 56.1 versus expectations of 53. Surprisingly, Markit Services PMI reached 56.2, marking the biggest expansion of the service sector in a year. Despite much fear about the effects that the fear of Brexit would have on property prices, house prices continue to rise at a healthy 4.5% pace, beating expectations. Report Links: Outlook: 2017's Greatest Hits -December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 AUD/USD has enjoyed a recent rally on the back of the greenback's decline. Additionally, the Australian services sector has improved considerably with the AiG Performance of Services Index recording a 6.6 point increase in November to 57.7. Although this may have contributed to the AUD bump, it is important to not look too much into this data as the Australian economy looks questionable - something we have discussed on several occasions. Australia's mining sector, China and emerging market uncertainty, a bearish outlook for commodity currencies and a USD bull market are all factors which will put downward pressure on AUD in the future. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 The kiwi reached its lowest level since June right before the New Year, dipping slightly below 0.69. Indeed some recent developments have proved negative for the NZD: Dairy prices have slowed down after their meteoric growth in the last half of 2016. GDP growth came at 3.5%, below expectations of 3.7%. Nevertheless structural forces appear to favor the Kiwi economy. First, permanent long-term migration in Auckland is at a 24-year high. Although, in the short term this should contain inflation as the supply of workers increases, in the long term the additional demand should boost the economy. Moreover, household credit growth continues to be healthy at almost 10% without being excessive, as it still is well below pre-2008 levels. These factors should boost the kiwi economy and provide long-term support for the NZD, at least compared to the AUD. Report Links: Outlook: 2017's Greatest Hits -December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 The Canadian dollar failed to appreciate against the dollar alongside rising oil prices after the Fed's December 14 monetary policy decision. For a moment, the Canadian dollar seemed to be more a function of the dollar than of oil. However, this decoupling is historically unprecedented and USD/CAD will soon revert back to its negative association with oil prices, especially due to the likely subdued movements in the dollar in the near future. A longer term outlook for CAD entails moderate downside. A dollar bull market will keep a lid on oil prices and be bullish for USD/CAD. Shorter-term momentum points to some strength in the CAD, with the MACD line surpassing the signal line and the 14-day RSI approaching oversold levels. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 USD/CHF should continue to mirror the behavior of the euro against the U.S. Dollar. While it is true that the euro area had strong data at the end of the year, continued dollar strength should cap any rally in the euro. Thus, USD/CHF should remain relatively unchanged. On the other hand, EUR/CHF is currently at 1.07, a level at which the SNB is very likely to intervene if it drifts any lower. The SNB has been very explicit that they will not tolerate any further currency appreciation, until deflationary pressures have started to dissipate. Given that inflation finished 2016 with a yearly growth of 0%, the SNB will not stop intervening any time soon. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 In a recent speech, Norges Bank Governor Oystein Olsen asserted that the economy has turned the corner, projecting real GDP growth of 1.5% in 2017 and above 2% in 2018 and 2019. He also pointed to the solid growth experienced by the non-oil sector. Wage growth, after falling for the past 8 years, also appears to have bottomed at around 2% and is now picking up. More importantly, leverage in the economy is very high and continues to grow, with debt as a percent of disposable income projected to reach close to 250% by the end of 2018. All of these factors could fortify already present inflationary pressures in the Norwegian economy. This will push the Norges Bank off its dovish bias, and consequently, thrust the NOK higher, particularly against its crosses. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The Riksbank's monetary policy meeting on Wednesday concluded with an unexpected outcome -the board considered the option to be able to immediately intervene on the market if necessary. It is clear that Swedish officials are making an adamant attempt in achieving their inflation target, clearing out any obstructions that may slow down inflation. It must be highlighted however that Governor Martin Flodén is reticent on this policy in the current situation, suggesting that intervention risk is not looming for the time being. Nevertheless, it is important to note that this instrument has been added to their toolkit. This decision most likely stems from the 4.5% decline in EUR/SEK since November 8 of last year. Since Europe represents 82% of Sweden's imports, a risk of importing deflation exists. We believe a level of around 9.000 to 9.1000 for EUR/SEK seems like a potential intervention trigger. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Special Report

Theme 1 - Returning U.S. Animal Spirits: I Want To Break Free Animal spirits are making a comeback in the U.S. The catalyst for this development is the hope that a Trump administration will alleviate the regulatory burden that has been a source of worry for corporate America (Chart I-1). Feeding this impression has been Trump's anti-regulation rhetoric. His deal-maker, take-no-prisoners persona, along with a cabinet packed with businessmen and corporate scions further solidifies this perception. However, Trump's electoral victory was only the match igniting the fuel. The conditions for a resurgence of animal spirits were already in place. Animal spirits are only a Keynesian metaphor for confidence. From late 2014 to 2016, a 16% contraction in profits weighed on business confidence. However, pre-tax profits have bottomed and are set to continue their acceleration (Chart I-2). Chart I-1Hurdle To Animal Spirits Chart I-2A Drag On CAPEX Vanishing Since profits have bottomed, business capex intentions have picked up steam. As Chart I-3 illustrates, this development not only tends to presage a rise in business investments, it also is a leading indicator of economic activity at large. This rise in capex intentions is not only a reflection of an ebbing contraction in profits. It also indicates that many companies are starting to worry about hitting their capacity constraints if final demand firms up. After having added to their real capital stocks at the slowest pace in decades, U.S. firms are now facing rising sales, a situation that creates a bottleneck (Chart I-4). Chart I-3CAPEX Intentions And Growth Chart I-4Improving Sales Outlook ##br##Meets Supply Constraint Moreover, the labor market is tightening. All the signs are there: at 4.6%, U.S. unemployment is in line with its long-term equilibrium; the number of individuals outside of the labor force is in line with the 1999 to 2007 period, an era where hidden labor-market slack was inexistent; and the difficulty for small businesses to find qualified labor is growing (Chart I-5). As is the case today, companies are not concerned by a lack of demand, but by the quality of labor - a combination pointing to decreasing slack - wage growth tends to accelerate. Coincidentally, this is also an environment in which companies increase their allocation to corporate investments (Chart I-6). A few factors explain why companies are more willing to invest when slack narrows and wages grow. Obviously, rising labor costs incentivize businesses to skew their production function toward capital instead of labor. Additionally, rising wages support household consumption. Capex is a form of derived demand. A stronger household sector leads to more perceived certainty regarding the robustness of the expected final demand faced by corporations. Thus, when the share of wages and salaries in the national income grows, so do investments (Chart I-7). Chart I-5The Labor Market Is Tight Chart I-6When Demand Is Solid And Labor Is Tight... Chart I-7Animal Spirits At Work This means that while we had already expected the consumer to be a key engine of growth next year, we expect the corporate sector to join the fray.1 To us, this combination represents the main reason to expect our Combined Capacity Utilization Gauge to move into "no slack" territory, an environment where the Fed can hike rates durably. Bottom Line: U.S. animal spirits are breaking free. Trump is the catalyst, but conditions for improving business confidence and higher capex have been in place for a period of time. Profits have troughed, capex intentions are on the rise, and capacity constraints are being hit. This will give the Fed plenty of ammo to increase rates in 2017 and 2018. Theme 2 - Monetary Divergences: Pretty Tied Up Monetary policy divergences will continue to be one of the running themes for 2017. As we have argued, the Fed is in a better position to increase interest rates. However, the European Central Bank and the Bank of Japan are firmly pressing on the gas pedal. Last week, the ECB unveiled a new leg to its asset purchase program. True, bond buying will decrease from EUR 80 billion to EUR 60 billion starting April 2017, but the program is now open-ended. Also, the ECB can now buy securities with a maturity of 1-year, as well as securities yielding less than the deposit facility rates. This gives the ECB more flexibility to increase its purchases if need be to placate any potential economic shock in the future. Most crucially, the ECB does not regard its 2019 inflation forecast of 1.7% as in line with its target. Draghi has stressed that this requires the ECB to persist in maintaining its monetary accommodation. This makes sense. While the European economy has surprised to the upside, the recent roll-over in core CPI highlights the continued deflationary forces in the euro area (Chart I-8). These deflationary forces are present because the European output gap remains wide at around 4% of potential GDP.2 While the OECD pegs the Eurozone's natural rate of unemployment at 9%, it is probably lower. Despite a 2.3-percentage-point fall in the Eurozone's unemployment to 9.8% since 2013, euro area wages continue to decelerate, in sharp contrast with the U.S. situation (Chart I-9). This portends to excess capacity in the European labor market. It also limits European household income growth, which has lagged the U.S. by 14% since 2003. (Chart I-9, bottom panel). As a result, European consumption should continue lagging the U.S. Chart I-8Europe's Deflation Problem Chart I-9Signs Of Slack In Europe Additionally, European domestic demand has been supported by a rise in the credit impulse - the change in credit flows (Chart I-10). Between 2011 and 2014, to meet the EBA stress test and Basel III criteria, European banks raised capital and limited asset growth, boosting their capital ratios from 7.1% to more than 11% today. Once this adjustment was over, European banks normalized credit flows, boosting the credit impulse. This process is behind us. To keep the credit impulse in positive territory, credit flows would have to keep on expanding, implying that the stock of credit would have to grow at an ever-accelerating pace. However, the poor performance of European bank equities suggests that credit growth will slow (Chart I-11). While this may be too pessimistic a forecast, it is now unlikely that credit growth will accelerate. As a result, the credit impulse will roll over, hurting domestic demand and keeping deflationary pressures in place. Chart I-10Credit Trends In Europe: Dark Omen Chart I-11Another Dark Omen This should translate into a very easy monetary policy in Europe for 2017 and most likely 2018. European rates, both at the short- and long-end of the curve will not rise as much as U.S. rates. In Japan, economic slack has dissipated and the labor market is at full employment (Chart I-12). The unemployment rate stands at 3% and the job-openings-to-applicants ratio sits at 1991 levels. What has prevented the Japanese output gap from moving into positive territory has been fiscal belt-tightening. Between 2011 and today, the Japanese cyclically-adjusted deficit has fallen from 7.5% to 4.5% of GDP, inflicting a large drag on growth. Going forward, we expect Japan's GDP to actually move above trend. Based on the IMF's forecast, fiscal austerity is behind us, suggesting that the force that has hampered growth is now being lifted. This is a conservative assessment. Abe has sounded increasingly willing to expand the government's deficit following his July upper-house election victory. Japanese military spending should be a key source of stimulus. In 2004, Japan and China both spent US$50 billion in that arena. Today, Japanese defense spending is unchanged but China's has grown to US$200 billion (Chart I-13). Therefore, Japan is ever more exposed to an increasingly assertive China in the region. Moreover, a potential rapprochement between the U.S. and Russia - a country formally still at war with Japan - also increases the need for a more self-sufficient Japanese defense strategy. Chart I-12Little Slack In Japan Chart I-13A Catch Up Is Needed Outside of the fiscal realm, there is cause for tempered optimism regarding Japan. Payroll growth remains strong despite full employment, pointing toward potentially higher wages. Also, the Business Activity Index, machinery orders, and the shipments-to-inventory ratio are all firming. Encapsulating these forces, our model forecasts further improvement in industrial production (Chart I-14). While these would point toward a monetary tightening, such is not the case in Japan. The Japanese central bank has committed to let inflation significantly overshoot before removing any accommodation. Hence, as growth improves, inflation expectations can rise, dampening real rates, depressing the yen, and further supporting growth (Chart I-15). This new BoJ policy is a game changer. Chart I-14Some Glimmer Of Hope Chart I-15The Mechanics Targeted By The BoJ Moreover, this policy becomes supercharged when global bond yields rise, a central view for BCA's U.S. Bond Strategy service in 2017.3 Due to their low beta, JGB yields tend to not rise as much as global yields in a bond selloff. With the BoJ targeting near-zero rates at the long-end of the curve, JGB yields have even less upside. Rising global bond yields result in even-wider-than-before global-Japan rate differentials, which hurts the yen. This will stimulate Japanese growth even further, additionally easing monetary policy. Bottom Line: While the U.S. is on the path toward tighter policy, the ECB and the BoJ, by design, are loosening their policy. In Europe, the economy continues to suffer from underlying deflationary forces, forcing the ECB to stand pat for now. In Japan, the BoJ has elected to let inflation overshoot significantly even as the economy strengthens. This is putting downward pressure on Japanese real rates, a de facto further easing of monetary policy. Theme 3 - China And EM Slow-Down: Livin' On A Prayer After a year of respite, in 2017, emerging markets and China will once again be a source of deflationary shocks for the global economy. EM as a whole remains in a structurally precarious position. Since 2008, EM economies have accumulated too much debt and built too much capacity (Chart I-16). Most worrying has been the pace of debt accumulation. In the past five years, debt-to-GDP has risen by 51 percentage points to 146% of GDP. The debt has been backed up with new investments, but such a quick pace of asset accumulation raises the prospects of capital misallocation. When a large economic block like EM spends more than 25% of its GDP for 13 years on investment, the likelihood that many poor investments have been made is high. EM economies show all the hallmarks that capital has been miss-allocated, threatening future debt-servicing capacity. Labor productivity growth has collapsed from 3.5% to 1.5%, despite rising capital-to-labor ratios, while return on equity has collapsed despite surging leverage ratios, a sure sign of falling return on capital (Chart I-17). Chart I-16EM Structural Handicaps Chart I-17Symptoms Of A Malaise With this backdrop in mind, what happened in 2016 is key to understanding potential 2017 developments. Excess debt and excess capacity are deflationary anchors that raise the vulnerability of EM to shocks, both positive and negative. In 2016, the shock was positive. In the second half of 2015 and early 2016, China engaged in large scale fiscal stimulus (Chart I-18). Government spending grew and US$1.2 trillion of public-private infrastructure projects were rolled out in a mere six months. This lifted Chinese imports from their funk, used up some of the EM's excess capacity, dampened EM deflationary forces, and raised EM return on capital for a period. Additionally, faced with volatile markets, Western central banks eased monetary policy. The ECB and BoJ cut rates, and the Fed backed away from its hawkish rhetoric. The resultant falls in DM real rates and the dollar boosted commodity prices, further dampening EM deflationary forces and boosting EM profitability. Capital flows into EM ensued, easing financial conditions there and brightening the economic outlook (Chart I-19). Chart I-18China Fiscal Backdrop: From Good To Bad Chart I-19EM Financial Conditions Are Deteriorating This process is moving into reverse, the positive shock is morphing into a negative one. The structural handicaps plaguing EM have only marginally improved. Precisely because the Chinese industrial sector has regained composure, the already-fading Chinese stimulus will fully move into reverse (Chart I-20). With credit appetite remaining low and interbank rates already rising as the PBoC slows liquidity injections, the Chinese economy should soon rollover. Moreover, the dollar and global real rates are on the rise. Paradoxically, the return of U.S. animal spirits could endanger the EM recovery. As Chart I-21 shows, an upturn in DM leading economic indicators presages a fall EM LEIs. This simply reflects relative liquidity and financials conditions. Chart I-20China: As Good As It Gets Chart I-21DM Hurting EM Strong advanced economies, especially the U.S., lifts DM real rates and the dollar. This process sucks liquidity away from EM and tightens their financial conditions exogenously (Chart I-22). This hurts EM risk assets, currencies, and their economies. Moreover, since trade with the U.S. and other DM economies only account for 15% and 13% of EM exports, respectively, a fall in EM currencies does little to boost growth there. The fall in EM growth to be seen in 2017 will lay bare their structural weaknesses. As a result, EM assets are likely to suffer considerable downside. EM economies will limit the rise in global inflation by exerting downward pressures on globally traded goods prices as well as many commodities. Moreover, with Europe and Japan more exposed to EM growth than the U.S. (Chart I-23), EM weaknesses would further contribute to monetary divergences between the Fed and the ECB/BoJ. Chart I-22Rising DM Rates Equal Falling EM Liquidity Chart I-23U.S. Is The Least Sensitive To EM Bottom Line: 2016 was a great year for EM plays as Chinese fiscal stimulus and easier-than-anticipated DM policy contributed to large inflows of liquidity into EM assets, supporting EM economies in the process. However, as Chinese fiscal stimulus moves into reverse and as DM rates and the dollar are set to continue rising, liquidity and financial conditions in EM will once again deteriorate. Theme 4 - Oil Vs. Metals: Good Times Bad Times From the previous three themes, a logical conclusion would be to aggressively short commodities. After all, a strong dollar, rising rates, and weak EM are a poisonous cocktail for natural resources. However, the picture is more nuanced. In the early 1980s, from 1999 to 2001, and in 2005, commodity prices did rise along with the dollar (Chart I-24). In the early 1980s, the rally in commodities was concentrated outside of the energy complex. The U.S. economy was rebounding from the 1980s double-dip recession, and Japan was in the middle of its economic miracle. Their vigorous growth resulted in a large positive demand shock, boosting Japan's and the U.S.'s share of global copper consumption from 34% to 37%. This undermined any harmful effect on metal prices from a rising dollar. In both the 1999-to-2001 and 2005 episodes, the share of U.S. and Japanese commodity consumption had already fallen. Most crucially, in both episodes, the rise in overall commodity price indexes only reflected strong energy prices. Outside of this complex, natural resource prices were lackluster (Chart I-25). Chart I-24Commodities And ##br##The Dollar Can Rise Together Chart I-25When A Commodity Rally Is An Oil Rally In these two instances, oil prices were able to escape the gravitational pull of a strong dollar because of supply disruptions. In 1999, following an agreement to reduce oil production by OPEC and non-OPEC states, output fell by around 4 million barrels per day, causing the market to re-equilibrate itself. In 2005, as EM growth was already creating a supportive demand backdrop, a devastating hurricane season in the Gulf of Mexico curtailed global production by around 1 million bbl/day. Today, the situation is a hybrid of 1999 and 2005. While EM economies are in a much weaker position than in 2005, the U.S. economy is gathering strength. Hence, close to 50% of global oil consumption - U.S. and DM oil demand - will stay firm (Chart I-26). But, most vitally, the supply picture once again dominates. Not only did OPEC agree to a deal to curtail production by 1.2 million bbl/day, but Russia agreed to share the burden, cutting its own output by 300 thousand bbl/day. Shortly after this agreement was reached, Saudi Arabia threw in an olive branch by pledging to further cut its production if necessary to reduce global oil inventories. This means that the oil market will firmly be in deficit in 2017 (Chart I-26, bottom panel). Our Commodity & Energy Service, which forecasted the OPEC move, believes WTI oil prices could occasionally peak toward US$65 /bbl in 2017.4 The picture for metals is more complex. The output of iron and copper continues to grow. On the demand side of the ledger, the U.S. only contributes 4% and 8% of global demand for each metal, respectively. Thus even if Trump were able to implement a large infrastructure program in 2017 - a big if for next year - the effect on global demand would be low. Instead, what matters for metal demand is the outlook for EM in general and China in particular (Chart I-27). On this front, our negative take on China and EM is a big hurdle for metals to overcome. Chart I-26Supportive Oil Back Drop Chart I-27Metals Are About China, Not The U.S. Yet, all is not dark. Metal and oil prices have historically been co-integrated. In fact, during the previous episodes where oil strengthened as the dollar rallied, metals have more or less been flat. This pattern is likely to repeat itself, especially if as we expect, EM experience a growth slowdown and not an outright recession. Altogether, expectations of strong oil prices and flat metal prices suggest that any EM slowdown should be more discriminating than in 2015 and early 2016. Countries like Russia and Colombia should fare better than Brazil or Peru. This reality is also true for DM economies. Canada and Norway are likely to outperform Australia. Bottom Line: Despite a bullish view on the dollar and a negative EM outlook, overall commodity indices are likely to rise in 2017. This move will mostly reflect a rally in oil - the benchmark heavyweight - a market where supply is being voluntarily constrained. The performance of metals is likely to be much more tepid, with prices mostly moving sideways next year. Theme 5 - Dirigisme: Sympathy For The Devil In 2017, a new word will need to enter the lexicon of investors: dirigisme. This was the economic policy of France after the Second World War. Dirigisme does not disavow the key support systems of capitalism: the rule of law, private property, the sacrosanct nature of contracts, or representative governments. Instead, dirigisme is a system of free enterprise where, to a certain degree, the state directs the economy, setting broad guidelines for what is admissible from the corporate sector. Donald Trump fully fits this mold. He wants business to be conducted a certain way and will try his hardest to ensure this will be the case. What will be the path chosen by Trump? Globalization and laissez-faire capitalism have been great friends of corporate profit margins and the richest echelons of U.S. society (Chart I-28). While it has also greatly benefited the EM middle class, the biggest losers under this regime have been the middle class in advanced economies (Chart I-29). As long as U.S. consumers had access to easy credit, the pain of stagnating incomes was easily alleviated. Without easy credit the pain of globalization became more evident. Chart I-28The (Really) Rich Got Richer Chart I-29Globalization: No Friend To DM Middle Class Trump has courted the disaffected middle class. While he is likely to cut regulation, he will also put in place potentially erratic policies that may destabilize markets. The key will be for investors to appreciate his ultimate goal: to boost, even if only temporarily, the income of the American middle class. As such, his bullying of Carrier - the U.S. air-conditioner manufacturer that wanted to shift production to Mexico - is only the opening salvo. Tax policy is likely to move in this direction. A proposed tax reform that would cut tax for exporters or companies moving production back to the U.S. towards 0 - that's zero - and punish importers is already in the pipeline. The implications of such policies on U.S. employment are unclear. While U.S. businesses may repatriate production, they may do so while minimizing the labor component of their operations and maximizing the capital component in their production function. In any case, more production at home will support the domestic economy for a time period. However, the global impact is clearer. These policies are likely to be deflationary for the global economy outside the United States. A switch away from production outside of U.S. jurisdiction will raise non-U.S. output gaps. This should weigh on global wages and globally traded goods prices. Additionally, this deflationary impact will cause global monetary policy to remain easy relative to the U.S., particularly hurting the currencies of nations most exposed to global trade. Compounding this effect, nations that currently export heavily to the U.S. - which will lose competitiveness due to tax policy shifts and/or potential tariffs - are likely to let their currencies fall to regain their lost competitiveness. The currencies of Asian nations, countries that have benefited the most from globalization, are likely to get hit the hardest (Chart I-30). Chart I-30Former Winners Become Losers Under Trump's Dirigisme Moreover, along with a shift toward dirigisme, the U.S.'s geopolitical stance could harden further, a troubling prospect in an increasingly multipolar world. Tensions in East Asia are likely to become a recurrent theme over the next few years. Ultimately, the rise of dirigisme means two things: First, the influence of politics over markets and economic developments will continue to grow. Economics is moving closer to its ancestor: political-economy. Second, while Trump's dirigisme can be understood as a vehicle to implement his populist, pro-middle class policies, they will add an extra dose of uncertainty to the global economy. Volatility is likely to be on a structural upswing. Interestingly, the risk of rising dirigisme is more pronounced in the U.S. and the U.K. than in continental Europe. Not only are economic outcomes more evenly distributed among the general population in the euro area, recent elections in Spain or Austria have seen centrist parties beat the populists. While Italy still represents a risk on this front, the likelihood of a victory by the right-wing Thatcherite reformist Francois Fillon for the French presidential election in May is very high.Germany will remain controlled by a grand coalition after its own 2017 elections.5 Bottom Line: The U.S. economy is moving toward a more state-led model as Trump aims to redress the plight of the U.S. middle class. These policies are likely to prove deflationary for the global economy outside of the U.S. and could support the U.S. dollar over the next 12-18 months. On a longer-term basis, the legacy of this development will be to lift economic and financial market volatility. Theme 6 - Inflation: It's A Long Way To The Top Our final theme for the upcoming year is that the inflationary outcome of a Trump presidency will take time to emerge and inflation is unlikely to become a big risk in 2017. Much ink has been spilled predicting that Trump's promises to inject fiscal stimulus exactly when the economy hits full employment will be a harbinger of elevated inflation. After all, this is exactly the kind of policies put in place in the late 1960s. Back then, due to the Great Society program and the deepening U.S. involvement in the Vietnam War, President Johnson increased fiscal stimulus when the output gap was in positive territory. Inflation ensued. This parallel is misleading. True, in the long-term, Trump's fiscal stimulus and dirigisme bent could have stagflationary consequences. However, it could take a few years before the dreaded stagflation emerges. To begin with, the structure of the labor market has changed. Unionization rates have collapsed from 30% of employees in 1960 to 11% today. The accompanying fall in the weight of wages and salaries in national income demonstrates the decline in the power of labor (Chart I-31). Without this power, it is much more difficult for household income to grow as fast as it did in the 1960s and 1970s. Likewise, cost-of-living-adjustment clauses have vanished from U.S. labor contracts. Hence, the key mechanism that fed the vicious inflationary circle between wages and prices is now extinct. Additionally, today, capacity utilization - a series that remains well correlated with secular inflation trend - remains much lower than in the 1960s and 1970s (Chart I-32). This means that one of the key ingredients to generate a sharp tick up in inflation is still missing. Chart I-31Labor: From Giant To Midget Chart I-32Capacity Utilization: Not Johnson Nor Nixon Chart I-33Today's Slack Is Not Where It Once Was Also, when looking at the output gap, the 1960s and 1970s once again paint a markedly different picture versus the present. Today, we are only in the process of closing the output and unemployment gaps. In the 1960s, it took U.S. inflation until mid-1968 to hit 4%. By that time, the output gap had been positive for around 5 years, hitting 6% of GDP in 1966. Unemployment had been below its equilibrium rate since 1963, and by 1968 it was 2.5% below NAIRU (Chart I-33). Together the aforementioned factors suggest that inflation should remain quite benign in 2017. We probably still have a significant amount of time before raising the stagflationary alarm bells. Finally, the Fed currently seems relatively unwilling to stay behind the curve for a prolonged period and let inflation significantly overshoot its target. Wednesday, the Fed surprised markets by forecasting three rate hikes in 2017, resulting in a much more hawkish communique than was anticipated. Therefore, the FOMC's tolerance for a "high pressure" economy now seems much more limited than was assumed by markets not long ago. This further limits the inflationary potential of Trump's stimulus. Instead, it highlights the dollar-bullish nature of the current economic environment. Bottom Line: Trump fiscal stimulus at full employment evokes the inflationary policies of the late 1960s and early 1970s. However, back then it took years of economic overutilization before inflation reared its ugly head. Additionally, the structure of the labor market was much friendlier to inflation back then than it is today. Thus, while Trump's policy may raise inflation in the long term, it will take a prolonged period of time before such effects become evident. Instead, in 2017, inflation should remain well contained, especially as the Fed seems unwilling to remain significantly behind the curve. Investment Implications USD The U.S. dollar is in the midst of a powerful bull market. While the USD is already 10% overvalued, the greenback has historically hit its cyclical zenith when it traded with more than a 20% premium to its long-term fair value. This time should be no exception. Beyond our positive view on households, resurging animal spirits are beginning to support the economy. This combination is likely to prompt the Fed to move toward a more aggressive stance than was expected a few months ago (Chart I-34). With monetary divergences fully alive and backed up by economic fundamentals, interest-rate spreads between the U.S. and the rest of the G10 will only grow wider. Factors like a move toward dirigisme and an absence of blow-out inflation will only feed these trends. Chart I-34Market's Fed Pricing: More Upside Tactically, the dollar is overbought, but clearly momentum has taken over. There is so much uncertainty floating in terms of economic and policy outcomes that evaluating the fair-value path for interest rates and the dollar is an even trickier exercise than normal for investors. This lack of clarity tends to be a fertile ground for momentum trading. Investors are likely to continue to chase the Fed. This process could last until market pricing for 2017 has overshot the Fed's own prognostications. Chart I-35EUR/USD: Technical Picture EUR At this point in time, the euro suffers from two flaws. First, as the anti-dollar, shorting the euro is a liquid way to chase the dollar's strength. Second, monetary divergences are currently in full swing between the ECB and the Fed: the U.S. central bank just increased interest rates and upgraded its rate forecast for 2017; meanwhile, the ECB just eased policy by increasing the total size of its asset purchase program. Investors are in the process of pricing these two trends and EUR/USD has broken down as a result (Chart I-35). The recent breakdown could bring EUR/USD to parity before finding a temporary floor. That being said, a EUR/USD ultimate bottom could still trade substantially below these levels. The U.S. economy is slowly escaping secular stagnation while Europe remains mired in its embrace. The euro is likely to end up playing the role of the growth redistributor between the two. JPY The Bank of Japan has received the gift it wanted. Global bond yields and oil prices are rising. This process is supercharging the potency of its new set of policies. Higher oil prices contribute to lifting inflation expectations, and rising global rates are widening interest-rate differentials between the world and Japan. With the BoJ standing as a guarantor of low Japanese yields, real-rate differentials are surging in favor of USD/JPY. USD/JPY has broken above its 100-week moving average, historically a confirming signal that the bull market has more leg. Additionally, as Chart I-36 shows, USD/JPY is a function of global GDP growth. By virtue of its size, accelerating economic activity in the U.S. will lift average global growth, further hurting the yen. Tactically, USD/JPY is massively overbought but may still move toward 120 before taking a significant pause in its ascent. We were stopped out of our short USD/JPY position. Before re-opening this position, we would want to see a roll-over in momentum as currently, the trend is too strong to stand against. GBP While political developments remain the key immediate driver of the pound, GBP is weathering the dollar's strength better than most other currencies. This is a testament to its incredible cheapness (Chart I-37), suggesting that many negatives have been priced into sterling. Chart I-36USD/JPY: A Play On Global Growth Chart I-37Basement-Bargain Pound For the first half of 2017, the pound will be victim to the beginning of the Brexit negotiations between the EU and the U.K. The EU has an incentive to play hardball, which could weigh on the pound. In aggregate, while the short-term outlook for the pound remains clouded in much uncertainty, the pounds valuations make it an attractive long-term buy against both the USD and EUR. Chart I-38CAD: More Rates Than Oil CAD The Bank of Canada will find it very difficult to increase rates in 2017 or to communicate a rate hike for 2018. The Canadian economy remains mired with excess capacity, massive private-sector debt loads, and a disappointing export performance. This suggests that rate differentials between the U.S. and Canada will continue to point toward a higher USD/CAD (Chart I-38). On the more positive front, our upbeat view on the oil market will dampen some of the negatives affecting the Canadian dollar. Most specifically, with our less positive view on metals, shorting AUD/CAD is still a clean way to express theme 4. AUD & NZD While recent Australian employment numbers have been positive, the tight link between the Australian economy and Asia as well as metals will continue to represent hurdles for the AUD. In fact, the AUD is very affected by theme 3, theme 4, and theme 5. If a move towards dirigisme is a problem for Asia and Asian currencies, the historical link between the latter and the AUD represents a great cyclical risk for the Aussie (Chart I-39). Tactically, the outlook is also murky. A pullback in the USD would be a marginal positive for the AUD. However, if the USD does correct, we have to remember what would be the context: it would be because the recent tightening in U.S. financial conditions is hurting growth prospects, which is not a great outlook for the AUD. Thus, we prefer shorting the AUD on its crosses. We are already short AUD/CAD and tried to go long EUR/AUD. We may revisit this trade in coming weeks. Finally, we have a negative bias against AUD/NZD, reflecting New Zealand's absence of exposure to metals - the commodity group most exposed to EM liquidity conditions, as well as the outperformance of the kiwi economy relative to Australia (Chart I-40). However, on a tactical basis, AUD/NZD is beginning to form a reverse head-and-shoulder pattern supported by rising momentum. Buying this cross as a short-term, uncorrelated bet could be interesting. Chart I-39Dirigisme Is A Problem For The Aussie Chart I-40New Zealand Is Perkier Than Australia NOK & SEK The NOK is potentially the most attractive European currency right now. It is supported by solid valuations, a current account surplus of 5% of GDP and a net international investment position of nearly 200% of GDP. Moreover, Norwegian core inflation stands at 3.3%, which limits any dovish bias from the Norges Bank. Additionally, NOK is exposed to oil prices, making it a play on theme 4. We like to express our positive stance on the NOK by buying it against the EUR or the SEK. The SEK is more complex. It too is cheap and underpinned by a positive current account surplus. Moreover, the inflation weaknesses that have kept the Riksbank on a super dovish bias mostly reflected lower energy prices, a passing phenomenon. However, being a small open economy heavily geared to the global manufacturing cycle, Sweden is very exposed to a pullback from globalization, limiting the attractiveness of the krona. Moreover, the krona is extremely sensitive to the USD. CHF The SNB is keeping its unofficial floor under EUR/CHF in place. Therefore, USD/CHF will continue to be a direct mirror image of EUR/USD. On a longer-term basis, Switzerland net international investment position of 120% of GDP and its current-account surplus of 11% of GDP will continue to lift its fair value (Chart I-41). Hence, once the SNB breaks the floor and lets CHF float - an event we expect to materialize once Swiss inflation and wages move back toward 1% - the CHF could appreciate violently, especially against the euro. Chart I-41The Swiss Balance Of Payment Position Will Support CHF Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 For a more detailed discussion of the consumer and the dollar, please see Foreign Exchange Strategy Weekly Report, "Dollar: The Great Redistributor", dated October 7, 2016, available at fes.bcaresearch.com. 2 Marek Jarocinski, and Michele Lenza, "How Large Is The Output Gap In The Euro Area," ECB Research Bulletin 2016, July 1, 2016. 3 Please see U.S. Bond Strategy Weekly Report, "Toward A Cyclical Sweet Spot?", dated November 22, 2016, available at usbs.bcaresearch.com. 4 Please see Commodity & Energy Strategy Weekly Report, "2017 Commodity Outlook: Energy", dated December 8, 2016, available at ces.bcaresearch.com. 5 For a more detailed discussion of dirigisme, multipolarity, and rising tensions in East Asia, please see Geopolitical Strategy Outlook, "We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. Currencies U.S. Dollar Chart II-1 Chart II-2 The Fed hiked rates to 0.75% as expected. The dollar began to rally soon after the updated dot-plot suggested a faster pace of tightening than previously expected. Data from Thursday morning displayed a strengthening labor market, with expectations consistently beaten: Initial Jobless Claims came in at 254 thousand, beating expectations of 255 thousand. Continuing Jobless Claims were recorded at 2.018 million, outperforming by 7 thousand. Additionally, the NY Empire State Manufacturing Index also outperformed expectations of 4, coming in at 9. These figures provided an additional lift to the dollar with the DXY nearing the 103 mark. Report Links: Party Likes It’s 1999 - November 25, 2016 One Trade To Rule Them All - November 18, 2016 Reaganomics 2.0? - November 11, 2016 The Euro Chart II-3 Chart II-4 The Euro Area's data releases seem to be a mixed bag. Industrial production failed to meet expectations, and even contracted 0.1% on a monthly basis. The Markit Composite PMI remained steady at 53.9, and was in line with expectations, while the Services PMI fell and underperformed expectations, whereas the Manufacturing PMI rose and beat expectations. The increase in the dollar has also forced down Euro, where it has broken the crucial support level of around 1.055, and traded as low as 1.04. Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Yen Chart II-5 Chart II-6 Despite the recent collapse in the Yen, Japan continues to be plagued by strong deflationary pressures. The BoJ will have no choice but to continue to implement radical monetary measures and thus the yen will continue to fall as some of the data lacks vigor: The decline in machinery orders accelerated to 5.6% YoY, underperforming expectations. Japanese industrial production is also contracting, at a pace of 1.4%. Particularly, most measures in the Tankan Survey (for both manufacturers and non-manufacturers) also underperformed expectations. Report Links: Party Likes It’s 1999 - November 25, 2016 One Trade To Rule Them All - November 18, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 British Pound Chart II-7 Chart II-8 Both the BoE and the market continue to be very bearish on the U.K. economy, causing the pound to be very cheap. However, the cable has remained resilient amid the recent dollar surge, in part because U.K. data, as we have mentioned many times, keeps outperforming expectations. The recent set of data confirms this view: Retail sales ex-fuel grew by 6.6% YoY, beating expectations of 6.1% YoY growth. Average earnings (both including and excluding bonus) also outperformed. Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Australian Dollar Chart II-9 Chart II-10 Australian new motor vehicle sales are still quite weak: They are contracting 0.6% on a monthly basis, albeit at a slower pace from October's 2.4%; On an annual basis, they are now contracting 1.1%. Labor market data was also released, with unemployment increasing to 5.7%. However, the change in employment was better than expected, with 39,100 new total jobs being added to the economy. The Consumer Inflation Expectation measure for December also highlighted an upbeat outlook on inflation, reading at 3.4%, up from 3.2%. Report Links: One Trade To Rule Them All - November 18, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 New Zealand Dollar Chart II-11 Chart II-12 The recent dollar rally has been very damaging for the kiwi, as it has fallen by 3% since the Fed policy decision. Recent data has also been negative: Manufacturing Sales slowed down to 2.1% in Q3 from 2.2% in Q2 (this number was also revised down from 2.8%). Additionally Business PMI slowed down slightly from 55.1 to 54.4. The NZD has also shown weakness in spite of the surge in dairy price, which now stand at their highest point since June 2014. Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 The Fed is Trapped Under Ice - September 9, 2016 Canadian Dollar Chart II-13 Chart II-14 The outlook for Canada's economy remains murky. Although the Financial Stability Report concluded that Canada's financial system remains mostly unchanged from six months ago, the BoC highlighted three key vulnerabilities that remain in the financial system: household debt, for which the debt-to-disposable income is approaching 170%; imbalances in the housing market, where the prices have reached just under 6 times average household income - their highest recorded level; and fragile fixed-income market liquidity. Therefore, underlying weaknesses are apparent and data is reflective of a weak economy. Pressure from a rising dollar will continue to place additional pressure on the CAD going forward. Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Swiss Franc Chart II-15 Chart II-16 The SNB decided to stay put and leave rates unchanged at -0.75%. In addition, the SNB slightly decreased its forecast for inflation for the coming years. However the central bank remains optimistic on the Swiss economy, as improved sentiment in other advanced economies should help the Swiss export sector. Additionally, the labor market remains solid, with only 3.3% of unemployment. Although the franc should continue to mirror the Euro, all these factors will eventually put upward pressure on this currency. Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Clashing Forces - July 29, 2016 Norwegian Krone Chart II-17 Chart II-18 The Norges Bank decided to stay put and leave rates at 0.5%. In their Executive Board Assessment the Norges Bank project that rates will remain around their current level in the coming years. They also project that inflation should slowdown given a somewhat slower expected path for growth. However, worries about household debt persist: House prices rose by 11.6% YoY in November, while household debt grew by 6.3%. Additionally household credit is rising faster than household income. Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Swedish Krona Chart II-19 Chart II-20 The Swedish economy has picked up a bit, as annual inflation figures came out at 1.4%, closer to the Riksbank's target. The labor market also displayed resilience as the unemployment rate dropped by 0.2% to 6.2%. Despite the upbeat data, the SEK failed to perform. With the dollar trading at new highs, USD/SEK also reached a new 13-year high, trading above 9.4 for a moment. Additionally, the SEK is trading poorly on its crosses as well, down against most of the G10 currencies. Report Links: One Trade To Rule Them All - November 18, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades