Currencies

Highlights Our main leading indicator for China’s economy and the broad trend in coincident measures both suggest that investment-relevant Chinese growth is set to slow over the coming months. Even in a trade deal scenario, an earnings recession for Chinese investable stocks looks likely unless the flow of credit soon increases to an annual pace of RMB 26 Trillion. The recent trend in money & credit growth is not yet consistent with this outcome. The RMB has risen relative to several currencies over the past two months, meaning that it does not simply reflect a weaker dollar. The RMB rally is linked to the trade negotiations with the U.S., suggesting that further gains are likely if a genuine truce emerges. Feature Tables 1 and 2 on pages 2 and 3 highlight key developments in China’s economy and its financial markets over the past month. On the growth front, our Li Keqiang (LKI) leading indicator continues to point to weaker activity over the coming 6-12 months, even though the LKI itself has actually trended higher over the past year. We maintain that trade frontrunning has caused this gap (which is in the process of unwinding), as broader measures of coincident activity have been trending lower and are poised to decelerate further. The growth rate of housing construction also seems set to decline, given that the current pace of starts is still running substantially above the pace of sales volume. Finally, while we do not expect the speed at which Chinese import and export growth decelerated in December to continue, the export components of China’s PMIs and the end of trade frontrunning both suggest that trade growth will remain weak over the coming few months. Table 1China Macro Data Summary   Table 2China Financial Market Performance Summary From an investment strategy perspective, we continue to recommend a neutral stance towards Chinese stocks within a global equity portfolio over a 6-12 month horizon, and remain tactically long until the end of this month. The recent outperformance of investable stocks vs. the global benchmark reflects global investor expectations of a trade deal between China and the U.S. later this month, but a deal alone will not reverse slowing domestic demand (which will negatively impact earnings). Even in a trade deal scenario, an earnings recession looks likely unless the flow of credit soon increases to an annual pace of RMB 26 Trillion, and the recent trend in money & credit growth is not yet consistent with this outcome. Finally, the rally in the RMB over the past two months does not simply reflect a weaker dollar, as it has risen relative to several currencies. The timing of the rally is clearly linked to the trade negotiations between the U.S. and China, suggesting that further gains are likely if a genuine truce emerges later this month. In reference to Tables 1 and 2, we provide several detailed observations concerning developments in China’s macro and financial market data below: Both the Bloomberg Li Keqiang index (LKI) and our alternative LKI rose to 9.3 in December, maintaining an uptrend that has been in place for the majority of the past 12 months. As we noted in last week’s report,1 this uptrend is not only in contrast to our leading indicator for China’s old economy, but also other coincident measures of economic activity. Chart 1 highlights that China’s investment-relevant economic activity is trending lower when broadly measured, implying that the uptrend in the LKI over the past 12 months is anomalous and is set to wane. Chart 1China's Investment-Relevant Economic Activity Is Trending Lower Our LKI leading indicator ticked down in December, as a rise in the RMB reversed some of the improvement in monetary conditions that had previously lifted the indicator. More important, however, is the very recent trend in the money & credit components of the indicator: while the YoY growth rates in M2, BCA’s calculation of M3, and adjusted total social financing (TSF) have recently stabilized, Chart 2 shows that the trend over the past three months has been down. We highlighted in last week’s report that Chinese credit growth needs to accelerate this year to avoid an earnings recession even assuming a trade deal with the U.S., and Chart 2 illustrates that the recent trend in money & credit growth is not yet consistent with this outcome. Chart 2The Recent Trend In Money & Credit Growth Is Down Based only on the trend in construction, China’s housing market is healthy and growing at a robust pace. However, fundamental support for the housing market is materially weaker: housing sales volume growth is in negative territory, growth in PBOC pledged supplementary lending injections has turned negative, and our house price diffusion indexes are rolling over from elevated levels. Housing sales volume has historically led the trend in construction, suggesting that China’s housing inventories are rising anew and that the pace of construction is set to cool significantly. The NBS and Caixin manufacturing PMIs for January provided conflicting readings: the former ticked up fractionally, whereas the latter deteriorated meaningfully further. The fact that the new export orders components of both PMIs moved higher in January suggests two things: 1) exporter sentiment is stabilizing (at a low level) in response to expectations of a trade truce with the U.S., and 2) the domestic demand outlook is weaker than the external outlook. This underscores that a framework trade deal with the U.S. at the end of the month is not, on its own, likely to lead to a significant reacceleration in the Chinese economy. Chinese investable stocks have rallied significantly in absolute US$ terms since the beginning of 2019, up over 11% year-to-date. Given that Chinese stocks are comparatively high-beta, most of this performance can be attributed to the rally in global stocks (up 8% YTD). However, it is notable that Chinese stocks outperformed global stocks both when the latter sold off aggressively in December, and in response to the recent global rally. This likely reflects global investor expectations of a trade deal between China and the U.S., which was the basis for our recommendation of a tactical overweight towards Chinese stocks in our December 5 Weekly Report.2 Chart 3 provides some additional evidence that global investors have driven the recent rally in investable stocks. First, panel 1 highlights that domestic stocks have underperformed investable stocks meaningfully over the past two months. Second, panel 2 shows that domestic infrastructure stocks, likely beneficiaries of a policy-driven reaccleration in domestic demand, have not rallied at all in absolute terms over the past few months. Chart 3Global Investors Drove The Recent Rally In Investable Stocks Within the equity sector space, the most notable development over the past month has been the substantial outperformance of Chinese consumer discretionary stocks (up almost 11% relative to global consumer discretionary in US$ terms year-to-date). For the most part, these gains reflect the idiosyncratic performance of Alibaba, due to recent changes to the global industrial classification standard (GICS).3 Prior to the changes, the automobiles & components industry group competed with retailing as a driver of the Chinese investable consumer discretionary sector; today, retailing accounts for 3/4ths of the index, with Alibaba accounting for all of the increase in retailer market cap (from 26% in November). Alibaba’s stock price recently bounced in response to a positive Q4 earnings surprise, but disappointing revenue growth underscores the challenges facing investable consumer discretionary stocks from deteriorating consumer sentiment in China.4 Despite the rally in China-related global financial assets over the past two months, Chinese onshore corporate bond spreads remain elevated in reflection of concerns over rising defaults (Chart 4). While we believe that investors are pricing in excessively high default rates over the coming year (i.e. the level of spreads is probably wider than warranted), the trend in onshore corporate spreads is highly informative and served as an early indicator that China’s economy was set to slow. Somewhat concerningly, the trend in spreads of different quality are not moving in a direction that would be consistent even with a stabilization in the Chinese economy. Panel 2 shows that AAA-rated corporate bond spreads have recently been trending higher, in contrast to that of bonds rated AA-. The former has reliably led the latter over the past year, implying that the odds of overall onshore spreads rising have gone up. Chart 4High-Quality Corporate Spreads Are Moving Higher The budding rally in the RMB that we identified last month has continued, with CNY-USD having recently broken above its 200-day moving average (Chart 5). Panels 2 and 3 highlight that this does not simply reflect a weaker dollar, as the RMB has risen relative to the euro and the basket of currencies included in the Bloomberg U.S. dollar spot index. It remains unclear whether this recent strength has been driven by trade talk-related intervention or market expectations of a trade deal, but its link to the negotiations is clear. This suggest that further gains are likely if a genuine truce emerges later this month. Chart 5A Genuine Rebound In The RMB   Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com     Footnotes   1 Please see China Investment Strategy Weekly Report “A Gap In The Bridge”, dated January 30, 2019, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report “2019 Key Views: Four Themes For China In The Coming Year”, dated December 5, 2018, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Special Report “GICS Sector Changes: The Implications For China”, dated September 26, 2018, available at cis.bcaresearch.com. 4 Please see China Investment Strategy Special Report “Chinese Household Consumption: Full Steam Ahead?”, dated November 14, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Special Report

Highlights The CAD and AUD have tactical upside; however, this may well prove to be the last hurrah before some serious declines play out. This time domestic – not global – factors will drive the CAD and AUD lower. Canada and Australia are hitting the end game for their respective debt supercycles as rising U.S. rates will lift the global cost of capital. Canadian and Australian house prices and debt loads are too elevated; a reversal of these excesses is likely to push these two countries toward liquidity traps. These liquidity traps will cause the R-star in Canada and Australia to fall, lagging well behind the U.S. Canada and Australia are uncompetitive, suggesting external demand will not come to their respective rescue, at least not until after the CAD and AUD have fallen significantly. The CAD may fall first, but the AUD has more downside ultimately; not only is Australia even less competitive than Canada, but the Aussie is also more expensive than the Loonie. Feature The Canadian and Australian dollars are in the process of rebounding. This is not surprising. By the end of 2018, both these currencies were deeply oversold, and the recent easing in global financial conditions, helped by the Federal Reserve’s pause, is fueling their rebound (Chart 1). Moreover, pessimism toward China has hit an extreme, yet Sino-U.S. trade relations seem on the cusp of improving and Chinese policymakers are increasingly trying to manage the downside in the Chinese economy. This setup is normally supportive for the Canadian and Australian dollars (Chart 2). Chart 1Financial Conditions Point To A Tactical Rebound In The AUD And The CAD...   Chart 2...So Does Chinese Reflation While we have been recommending that our more tactically minded clients play this rally,1  the longer-term outlook for the CAD and AUD remains poor. These countries are getting closer to the end of their respective debt supercycles. Consequently, the CAD and AUD need to trade at much larger discounts to fair value in order to be attractive. Way Too Much Debt Canada and Australia have become victims of their own success. Canada and Australia have seen real estate prices rise for more than two decades. At first, rising prices reflected solid valuations, growing populations and rising prosperity. However, things changed around the Great Financial Crisis. During this traumatic event, the Bank of Canada and the Reserve Bank of Australia both dropped interest rates by 4.25%. Since both countries’ banking sectors escaped the crisis unscathed, and households did not experience similar losses of wealth as those in the U.S., Ireland or Spain, credit growth remained strong. A real estate bubble became the natural consequence of this easy monetary policy. Banks pushed credit to households, and households – impressed by the solid performance of real estate prices, attracted by low interest rates, and enamored with the dream of easy riches – willingly took on mortgages and piled into the property market. A feedback loop ensued, whereby rising collateral values made credit even easier to access, fomenting further house price gains and even-easier credit conditions. Today, we stand at the end of this process. Vancouver and Toronto in Canada, and Sydney and Melbourne in Australia are some of the most expensive real estate markets in world in terms of price-to-income ratios, when one controls for population density (Chart 3). This has created major systemic risks for both countries. Few would care about the systemic risk created by elevated house prices if debt loads were small. However, in both countries, household indebtedness makes Americans circa 2007 look like a frugal bunch. In Canada, household debt has now reached 176% of disposable income, or 100% of GDP, while in Australia, the same ratios are 189% and 121%, respectively. This is well above the levels that prevailed in the U.S. in 2007 (Chart 4). Mortgage debt alone represents 108% and 140% of disposable income in Canada and Australia, respectively. Moreover, Canadian and Australian households also spend 14.5% and 15.6% of their incomes servicing debt, which also compares unfavorably with the U.S. in 2007. Chart 4ACanadians And Australians Make Americans Look Frugal Chart 4BCanadians And Australians Make Americans Look Frugal Canadian and Australian households thus seem close to having reached their maximum debt loads. Moreover, measures taken in Canada and Australia to limit foreign money inflows and constrain bank lending are beginning to bite. In both countries, real estate transactions are slowing, with property sales declining by 20% and 8% in Canada and Australia, respectively. House prices too are being hit. House prices in Vancouver and Toronto peaked by 2018, and in Sydney and Melbourne in 2017. Residential construction is likely to be the first victim. Real estate inventories in both these countries have been rising, courtesy of the frenetic pace of housing starts going on for decades. Today, residential investment represents 7% of GDP in Canada and 5% of GDP in Australia (Chart 5). Thus, slowing real estate activity could curtail Canadian and Australian GDP by 2% if we move back to the real estate environment that prevailed in the mid-1990s. This would also imply large hits to employment as construction, real estate and finance have created 336-thousand and 250-thousand jobs in Canada and Australia since 2009, respectively. Chart 5AA Decline In Construction Activity Would Be A Vicious Hit To Canada And Australia (1) Chart 5BA Decline In Construction Activity Would Be A Vicious Hit To Canada And Australia (2) Consumption too is likely to suffer. Without a growing wealth effect and with declining equity in their houses, Canadian and Australian households are likely to curtail consumption – consumption that has contributed 60% and 30% of Canada’s and Australia’s cumulative GDP growth since 2009. Already, we are seeing slowing Canadian and Australian retail sales – right behind drops in housing activity. The biggest and most dangerous risk is that Canada and Australia teeter on the verge of falling into a liquidity trap, like the U.S. after 2007. As Chart 6 illustrates, propelled by households binging on cheap money in the form of mortgages, Canadian and Australian banks have managed to maintain higher levels of return on equity after the financial crisis. This robust profitability will decline if non-performing loans, which so far remain low, grow in response to weakening house prices and fragile household financial health (Chart 7). Chart 6Canadian And Australian Banks Remain Profitable... Chart 7...As Long As NPLs Do Not Rise Rising NPLs and declining RoEs tend to limit the willingness of banks to lend. Just as crucially, the poor health of households and falling real estate prices is likely to also limit demand for credit. This combination was behind the sharp decline in the U.S. money multiplier in 2008. No matter how much reserves the Federal Reserve would inject in commercial banks via QE programs, broader money would not respond. A similar fate is likely to ensue in Canada and Australia (Chart 8). The velocity of money is also likely to fall if households are not willing to take on debt anymore and instead focus on rebuilding their financial buffers. Chart 8Canada And Australia Have Avoided A Liquidity Trap... So Far The consequence of this monetary constipation will be much lower interest rates. When an economy enters a liquidity trap, as was the case in the U.S. after 2007, in Japan since the 1990s, or in Europe after 2010, the neutral real rate of interest, the so-called R-star, falls to zero or even lower. Essentially, no matter how low interest rates fall, they cannot equilibrate the demand and supply for savings. Everyone wants to save, no one wants to borrow, and banks are unwilling to lend. This fate looks increasingly likely for both Canada and Australia over the coming two years. Bottom Line: The Canadian and Australian real estate markets have enjoyed incredible runs for more than two decades. Now, not only are real estate prices in these two nations very expensive, households have been left with prodigious debt loads. As real estate activity slows, residential construction will suffer, but most importantly, these two countries are likely to teeter toward becoming liquidity traps as banks curtail lending and households curtail borrowing. This will result in structurally lagging interest rates. Why Now? Betting on the end of the Canadian and Australian housing bubbles has so far been mugs games. Why is the situation different now? Because the U.S. economy is stronger. Until now, very low global interest rates have kept the Canadian and Australian housing bubbles afloat, but rising U.S. interest rates are now putting upward pressure on mortgage rates in both Canada and Australia (Chart 9). This simply reflects the fact that U.S. rates represent the ultimate opportunity cost of investing outside the international reserve currency, the U.S. dollar. After years of household deleveraging, the U.S. seems to be able to handle higher rates. However, because Canadian and Australian balance sheets are much weaker, their tolerance for higher rates is substantially lower. Chart 9Higher U.S. Rates Threaten Canadian And Australian Households BCA sees further upside for U.S. rates and thus for the global cost of capital. In other words, we do not anticipate the Fed’s pause to last beyond June. The following reasons underpin this view: The U.S. labor market is increasingly inflationary. The employment-to-population ratio for prime-age workers continues to rise, which historically has boosted labor costs (Chart 10). The New York City Fed Underlying Inflation Gauge points toward higher core inflation (Chart 11). Moreover, Ryan Swift argues in BCA’s U.S. Bond Strategy that an unfavorable base effect will dissipate after February, further reinforcing the upside risk to inflation.2  Being the only component of our Fed Monitor moving toward “easy money required” territory, the tightening in U.S. financial conditions last year was the lynchpin behind the Fed’s pause. The other components of the Fed Monitor have not deteriorated significantly, and they still argue in favor of further rate hikes (Chart 12). Thus, if the recent easing in financial conditions can persist, the Fed will hike again this year.   Chart 11Budding U.S. Inflationary Pressures   Chart 12The Fed Is Pausing Because Of Tightening Financial Conditions, Not The Economy Finally, U.S. productivity is set to pick up over the coming two years. Since a rising capital stock boosts productivity, the recent strength in capex augurs well (Chart 13). Moreover, the demand deficit created by the deleveraging of U.S. households has weighed on productivity. As U.S. credit growth picks up, so will productivity. This is important as rising productivity lifts the neutral rate, and thus creates more room for the Fed to lift interest rates. Chart 13Upside For U.S. Productivity Equals Upside For U.S. Rates Ultimately, all these factors point to higher U.S. rates. As such, it suggests that Canadian mortgage rates, and to a lesser extent Australian ones as well, will experience upward pressure – exactly at the time when households in these two countries are most vulnerable to higher rates. Bottom Line: Higher U.S. rates are the main reason why we expect the Canadian and Australian housing markets and economies to buckle now, finally heeding the call of doomsayers. Higher U.S. rates lift the global cost of capital. While U.S. households are in robust shape and therefore better able to handle higher rates, the same cannot be said about Canadian and Australian households. Can the External Sector Come To The Rescue? This is unlikely. After years of commodity booms and strong domestic demand supported by rising household wealth, the Canadian and Australian manufacturing sectors have been greatly diminished. Much capacity has vanished, and it will be difficult to replace the lost output from falling domestic demand by exports of manufactured goods. The Australian and especially the Canadian corporate sectors are also already heavily indebted, and thus, it could take quite some time before capacity is expanded. Complicating the situation, Canada and Australia are not competitive exporters anymore. As the top panel of Chart 14 shows, since 1980, U.S. unit labor costs have risen by 156%, but they have risen by 183% in Canada and by a stunning 282% in Australia. Productivity trends paint a similar, albeit less dramatic picture. Since 1980, U.S. labor productivity has risen 22% versus its trading partners; in Canada it has declined by 20%, and in Australia, by 5%. Consequently, both Canadian and Australia labor will have to cheapen. Historically, the mechanism through which labor costs decline is higher unemployment, which forces a painful adjustment in wages. These adjustments are likely to force both interest rates and currencies lower. Chart 14Canada And Australia Are Uncompetitive Could China come to the rescue? Via higher commodity prices, both Canada and Australia have been major beneficiaries of the Chinese economic boom. However, while China today is trying to contain its economic deceleration, Chinese policymakers remain fixated on controlling credit growth. This means that China is unlikely to go on another debt binge similar to what transpired in 2009 or in 2015-‘16. As a result, the recent uptick in commodity prices is unlikely to last long. More fundamentally, China is not only trying to move away from its debt-led growth model: It is also trying to move away from its investment-led growth model. This means that the commodity intensiveness of the Chinese economy is likely to decline. China’s emphasis on controlling air pollution will strengthen this trend. As Chart 15 illustrates, when the share of Capex as a percentage of Chinese GDP declines, so does the labor participation rate of Canada and Australia relative to the U.S. This decline in relative participation rates is associated with falling CAD and AUD values versus the U.S. dollar, a consequence of falling growth potential and interest rates. Chart 15AChanging Chinese Growth Model Points To Falling Canadian And Australian Participation Rates (1) Chart 15BChanging Chinese Growth Model Points To Falling Canadian And Australian Participation Rates (2) Bottom Line: Canada’s and Australia’s lack of manufacturing capacity, poor competitiveness, and China moving away from its investment-led growth model suggest that a deflationary environment will ultimately develop in these two nations, at least relative to the U.S. Moreover, the structurally negative outlook on consumption, debt growth and employment suggests that Canadian and Australian neutral rates are likely to fall relative to the U.S. These economic forces point to deeper lows this cycle in the CAD and AUD against the USD. Investment Implications Based on this economic backdrop, both the Canadian and Australian dollar could suffer significant downside in the coming years as their fair value is likely to fall, dragged by interest rates that will lag those in the U.S. However, if an asset is cheap enough, it may nonetheless be an attractive buy. The CAD and AUD do not fall into that camp. Today, the CAD trades in line with our long-term fair-value model, implying that if its fair value falls, the CAD provides zero insulation and will therefore also have to decline. The AUD is in an even worst spot as it currently trades above its fair value (Chart 16). Additionally, the Australian current account deficit is larger than Canada’s. Chart 16The CAD And AUD Are Not Cheap Enough To Compensate For Secular Risks In terms of timing, the Loonie could start weakening before the Aussie. The Canadian housing bubble is likely to collapse first as Canadian mortgage rates are more tightly linked to U.S. ones than Australian rates are. Moreover, the Canadian economy seems even more levered to rising real estate prices than that of Australia. However, a collapse in Vancouver and Toronto housing prices will promptly catalyze similar weaknesses in Sydney and Melbourne. Thus, while the CAD may be the first to take the great plunge, the AUD will not be far behind. Ultimately, the AUD will suffer the greatest decline. Obviously, the more onerous pricing of the AUD contributes to this assessment, but so does the greater lack of competitiveness in Australia than in Canada. Australia is likely to endure deeper deflationary pressures as its labor costs need greater adjustments. Furthermore, Australia already suffers from a larger degree of underutilized labor than Canada. Since the currency – not wages – is likely to withstand the bulk of the competiveness adjustment, this implies that the AUD has more work to do than the CAD. The more expensive valuations of Australian assets also handicap the Aussie versus the Loonie. Australian real estate is pricier than Canadian property, and Australian stocks are more expensive (Chart 17). This means that Australians could end up with deeper holes in their balance sheets than Canadians, and that Australia has scope to witness greater outflows of capital than Canada. Chart 17Canadian Financial Assets Are Cheaper Than Australian Ones... Where Australia shines relative to Canada is in terms of the ability of fiscal authorities to respond to an economic slowdown. Canadian public debt stands at 90% of GDP versus 41% of GDP in Australia. Canada’s cyclically-adjusted primary deficit is already deteriorating, while Australia’s is improving (Chart 18). This means that the Australian governments have deeper pockets and a greater capacity to support domestic demand than Canada’s. This could cushion the deflationary impact in Australia relative to Canada. That being said, the Japanese, Spanish or U.S. experiences argue that once a real estate bubble bursts, fiscal spending can cushion some of the pain, but it cannot eradicate the problem – at least not until banks are recapitalized and the private sector is once again ready to borrow, something that takes years of balance-sheet rebuilding. Chart 18...But Australia Has More Fiscal Space Bottom Line: Both the CAD and AUD are likely to experience substantial downside over the coming years. The CAD and AUD are not cheap enough to compensate for a BoC and RBA that will greatly lag the Fed. While the CAD may weaken first, the AUD will suffer more long-term downside. The Aussie is more expensive, Australia is less competitive than Canada, and it could suffer greater outflows of capital. Continue to underweight Australian and Canadian assets in global portfolios as the AUD and CAD will drag their performance down. Remain short AUD/CAD on a structural basis.   Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Weekly Report, titled “Global Liquidity Trends Support The Dollar, But…”, dated January 25, 2019, 2018, available at fes.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, “Buy Corporate Credit”, dated January 15, 2019, available at usbs.bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Feature Half Way Back Since BCA went overweight global equities in late December, the MSCI ACWI index has rallied by 8% and the S&P 500 is back to only 8% off its September historical high. So far, this has been little more than a technical rally from the extreme oversold position in Q4. But with U.S. economic growth still resilient, earnings likely to grow healthily again this year (albeit more slowly than in 2018), and the valuation of risk assets (both equities and credit) no longer a headwind, we expect the rally to continue for some time, and so reiterate our overweight on equities. Recommendations True, there have been some disappointments in U.S. data in recent weeks. In particular, the December manufacturing ISM fell sharply to 54.3 from 59.3, raising fears that the U.S. is starting to decelerate in line with other regions (Chart 1). But the ISM may have been affected by the government shutdown and, overall, U.S. data still look solid, with the Citigroup Economic Surprise Index beginning to rebound, and stronger than in other regions (Chart 2). The residential housing market, which was exhibiting signs of stress last year, with existing home sales -6.4% YoY in December, is showing the first signs of stabilization, helped by mortgage interest rates that are now 50 BPs off their recent peak (Chart 3). Chart 1How Worrying Is The U.S. Slowdown? Chart 2U.S. Data Surprisingly Positive Chart 3Housing Market Should Stabilize In particular, the outlook for consumption looks healthy, with average hourly earnings growing at 3.3% YoY, consumer confidence close to an historic high, and the savings rate above 6%. Unsurprisingly, then, retail sales have boomed in recent months (Chart 4). Unless consumer confidence is dented by a repetition of the government shutdown or some other shock, consumption (68% of GDP, remember) should grow strongly this year. Add to this a residual positive impact of close to 0.5% of GDP coming from last year’s fiscal stimulus, and it is hard to imagine the U.S. going into recession over the next 12 months. Chart 4Consumption Booming The Fed will probably go on hold for now, however, given the market jitters in Q4. We are likely back to a situation like that in 2015-2016, where the Fed Policy Feedback Loop becomes the key factor for markets (Chart 5). When financial conditions tighten, with stock prices falling and the dollar appreciating, the Fed turns more dovish. However, this triggers a rally in risk assets and loosens financial conditions, allowing the Fed to start hiking again. With the tightening in financial conditions over the past six months, the Fed is likely to err on the side of caution for now (Chart 6). However, if our macro view is correct – and as inflation starts to pick up again after April, partly due to the base effect – the Fed will want to continue withdrawing accommodation over the course of this year. The Fed Funds Rate, at around 2.4% is still two hikes below what the FOMC sees as the neutral level of interest rates (the 2.8% terminal rate in the FOMC dots). We see the Fed, therefore, raising rates in June and perhaps hiking two or even three times this year. By contrast, the futures market assigns only a 25% probability of even one rate hike this year, and is even pricing in a small probability of a cut. Chart 6Tighter Conditions Mean More Cautious Fed Clearly, there are plenty of risks to the scenario of growth continuing. But those in the hands of President Trump, especially the trade war with China and the fight over funding of the wall on the border with Mexico, we don’t see as being serious impediments. Trump is fully aware that he is unlikely to be reelected in November 2020 if the U.S. is in recession by then. Every incumbent U.S. president since World War Two who fought for reelection during a recession failed to be reelected (Chart 7). The view of BCA’s geopolitical strategists, therefore, is that the White House and Congressional Democrats will agree to concessions to end the shutdown before the end of the current three-week stop-gap period. Less likely, Trump will declare a national emergency that will cause much controversy but have little impact on the economy. Our strategists also argue that there is a 45% probability of trade negotiations with China producing a result (at least a short-term one the president can boast about) before the March 1 deadline, and a further 25% probability of the deadline being extended without further sanctions being imposed.1 Chart 7Trump Won't Be Reelected In A Recession Equities: Analysts have become overly pessimistic about the earnings outlook for this year, cutting 2019 U.S. EPS growth to 7% (and only 2% YoY in Q1). Our top-down model (based on, admittedly optimistic, U.S. growth assumptions, but also headwinds from a stronger dollar) indicates 12% growth. If analysts are forced to revise up their numbers as better earnings come through, that should be a catalyst for further equity performance (Chart 8). We continue to prefer U.S. over European equities. The steady slowdown in European growth over the past 12 months has not yet bottomed, banks in Europe remain troubled, the earnings picture is less positive, and valuations relative to the U.S. are not especially attractive. We also remain underweight on EM equities: they may produce a positive return in a risk-on environment, but we see them underperforming DM as rising U.S. interest rates and a stronger USD put pressure on EM borrowers with excess foreign-currency debt. Chart 8Analysts Have Overdone Downward Revisions Fixed Income: The recent fall in U.S. Treasury yields was mainly caused by the inflation expectation component, itself very sensitive (if rather illogically so) to the oil price (Chart 9). As the oil price recovers (see below), inflation picks up moderately, and the Fed hikes by more than the market expects, we see the 10-year Treasury yield rising to 3.5% during the course of the year. BCA’s fixed-income strategists recently raised their recommendation on global credit to overweight, given more attractive spreads and the likelihood that the Fed will be on hold for the next six months.2 Their recommendation is for 3-6 months, and the Fed restarting the hiking cycle, say in June, might terminate the positive story. We are following their lead, by raising both high-yield and investment-grade bonds to overweight within the (underweight) fixed-income asset class. That means we are neutral credit in the overall portfolio. We would warn, though, that this is a somewhat short-term call: we still prefer equities as a way to play the continuing risk-on rally. Given the high level of U.S. corporate leverage, and the over-owned nature of the credit market, this is likely to be an asset class that performs very poorly in the next recession (Chart 10). Chart 9Inflation Expectations Should Recover Chart 10Corporate Leverage Is A Concern Currencies: Currencies will continue to be driven by relative monetary policy. With the growth desynchronization between the U.S. and other DMs set to continue (to a degree), we see modest further USD appreciation this year. The Fed (as argued above) will probably hike more than the market expects. But, given slow European growth, the ECB is unlikely to be able to hike in Q4 this year, as it currently is guiding for and the futures market implies (Chart 11). We see the ECB reopening the Targeted Long-Term Repo Facility (TLTRO), which expires soon. Italy and Spain have been big borrowers from this facility, and bank loan growth is likely to slow as it ends (Chart 12). A renewed TLRTO would be seen as a dovish move. Tighter dollar liquidity conditions also point to a stronger USD. U.S. credit growth continues to accelerate (to 12% YoY – Chart 13) in an environment where the monetary policy has tightened: credit growth is outpacing U.S. money supply growth by 7%. Historically this has been negative for global growth (mainly because the deteriorating liquidity is a problem for EM dollar borrowers) and positive for the dollar (Chart 14).3 Chart 11Can ECB Really Hike In 2019? Chart 13...U.S. Loan Growth Accelerating... Chart 14... Which Will Tighten Liquidity Further Commodities: The supply/demand situation for oil should improve over coming months. With Saudi Arabia and Russia committed to cut supply by 1.2 million barrels/day, U.S. shale production growth slowing given the low one-year forward price for WTI, Canada reducing production, and Venezuela on the verge of collapse (which alone could remove 700-800k b/d from the market), our energy strategists see the crude oil balance in deficit over the next four quarters (Chart 15). Given this, they forecast Brent crude rebounding to above $80 a barrel. Other commodity prices are mostly driven by Chinese demand. We see China continuing to slow, until the accumulated effects of its fiscal and mild monetary stimulus start to come through in H2 and stabilize growth. Our analysis suggests that China remains very disciplined about the size and nature of its stimulus: it is not turning on the liquidity taps as it did in early 2016. Bank loan growth has stabilized, but shadow banking activity continues to contract, as the authorities persist with their crackdown and their emphasis on deleveraging (Chart 16). Industrial commodities prices are therefore likely to weaken over the next six months.  Chart 15Oil Balance In Deficit This Year Chart 16China Sticking To Credit Crackdown   Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com   GAA Asset Allocation Footnotes 1      Please see Geopolitical Strategy Weekly Report, “So Donald Trump Cares About Stocks, Eh?”, dated 9 January 2019, available at gps.bcaresearch.com 2      Please see Global Fixed Income Strategy Weekly Report, “Enough With The Gloom: Upgrade Global Corporates On A Tactical Basis,” dated 15 January 2019, available at gfis.bcaresearch.com 3      For a detailed explanation, please see Foreign Exchange Strategy Weekly Report, “Global Liquidity Trends Support The Dollar, But…,” dated 25 January 2019, available at fes.bcaresearch.com

Highlights We advocate implementing asset allocation not across EM assets, but rather relative to their DM counterparts. EM stocks should be part of a global equity portfolio. EM sovereign and corporate credit should be part of a global credit portfolio. EM local currency government bonds are a unique asset class with idiosyncratic features and a low correlation with other assets. Hence, their addition to any multi-asset class portfolio is beneficial. We continue recommending below benchmark allocation to EM equities, credit and local bonds. The rebound in various EM financial markets is reaching a critical technical level where it will either stop or, if broken, will carry on for some time. In Peru, further decline in industrial metals prices and ongoing involuntary monetary tightening bode ill for share prices; continue underweighting. Feature We frequently receive questions from our clients on how they should be positioning their portfolios within EM asset classes such as equities, EM U.S. dollar bonds (credit markets) and local currency government bonds – whether they should be overweight EM stocks versus EM credit markets and domestic bonds, or vice versa. While BCA’s Emerging Markets Strategy service covers EM stocks, credit and domestic bonds and exchange rates, we do not make asset allocation calls between EM equities, EM credit and local currency bonds. The reason is very simple: in a risk-on market, EM equities always outperform EM credit and local bonds, and in a risk-off environment, stocks always underperform fixed income (Chart I-1). Chart I-1EM Stocks Versus EM Credit And Local Bonds With respect to the relative performance of EM credit markets versus domestic bonds, the performance of EM currencies is key. A large portion of total returns on EM local currency bonds comes from exchange rates (Chart I-2). Hence, when EM currencies appreciate, domestic bonds outperform EM credit markets (U.S. dollar bonds), and vice versa (Chart I-3). Chart I-2EM Currencies Are Key To EM Local Bonds Returns Chart I-3EM Local Bonds Versus EM Credit: It Is A Currency Call For investors willing to allocate across EM asset classes, a directional view on financial markets should drive allocation between equities and fixed-income. In rallies, equities should be favored, while during risk-off periods, fixed income should be preferred. It follows that investors should overweight EM credit markets versus domestic bonds when EM currencies depreciate, and tilt allocation toward local currency bonds versus EM credit markets when EM exchange rates appreciate. Recommended Approach To Asset Allocation We advocate implementing asset allocation not across EM assets, but relative to their DM counterparts: EM stocks should be part of a global equity portfolio. A pertinent asset allocation decision should be whether to be overweight, neutral or underweight EM within a global equity portfolio. In short, EM stocks should not be compared with EM credit or local bonds, but rather versus their DM counterparts. Having mentioned that, we are maintaining our underweight recommendation on EM within a global equity portfolio for now. EM sovereign and corporate credit should be part of a global credit portfolio – i.e., asset allocators should compare them with other credit instruments such as U.S. and European corporate bonds. Total returns on EM U.S. dollar-denominated sovereign and corporate bonds can be deconstructed into the total return on U.S. Treasurys and the excess return of these EM bonds over U.S. Treasurys. Investors can obtain exposure to U.S. Treasurys by owning them outright. Hence, the unique feature of EM sovereign and corporate bonds is their spreads over U.S. government bonds. EM sovereign and corporate bond spreads over U.S. Treasurys reflect issuers' ability and willingness to pay. Thereby, investors should treat EM dollar-denominated bonds as a pure credit product and this asset class should be part of a global credit portfolio. At the moment, we recommend asset allocators underweight EM sovereign and corporate credit versus U.S./DM corporate credit, in line with our short EM equities/long U.S./DM equities strategy (Chart I-4). Within credit markets, EM investment-grade and high-yield credit should be compared with their peers in U.S./DM, respectively. The reason we are negative on EM credit markets relative to the U.S. and DM universe is that the majority of EM sovereign and corporate bond issuers in Latin America and the EMEA are commodity producers. Hence, their revenues fluctuate with commodity prices, and their spreads should be under upward pressure as commodity prices drop further and EM currencies correspondingly depreciate (Chart I-5). Chart I-4EM Credit Versus U.S. Credit Chart I-5EM Credit Spreads Are Sensitive To Commodities And EM Currencies In the meantime, Chinese property companies, financials and industrials/materials remain the largest issuers of corporate debt in emerging Asia. Specifically, U.S. dollar bonds issued by Chinese companies account for 32% of the Barclay’s overall EM USD Credit index and 56% of the EM Asia USD Credit index. Crucially, Chinese corporate credit is essential to trends in emerging Asian credit markets. We are bearish on the fundamentals of Chinese corporate bond issuers due to our negative view on Chinese capital spending, particularly in the real estate sector. With respect to EM local-currency government bonds, this is an entirely different asset class with returns often uncorrelated with any other asset. Table 1 shows that EM local currency bond returns in U.S. dollars have a low correlation with most other asset classes. Therefore, adding EM local-currency bonds to a global multi-asset class portfolio will help achieve risk diversification provided an expectation of a positive return on this asset class in the long run. EM domestic bond returns are comprised of local yield carry and capital gains/losses, as well as currency appreciation/depreciation. Business cycles and monetary policies could from time to time be desynchronized across EM countries, and EM currencies could also at times diverge. In short, all of this will add idiosyncratic risk to any global multi-asset class portfolio and push out the portfolio’s efficient frontier – i.e., the portfolio could achieve higher returns for the same amount of risk (volatility). The exposure to EM local currency bonds should be altered according to the view on this asset’s absolute performance. Presently, we recommend below benchmark allocation to this asset class because we expect the majority of EM currencies to depreciate versus the U.S. dollar, the euro and the Japanese yen. The key driver of EM currencies is not U.S. interest rates but the global business cycle (Chart I-6). Odds are high that global trade will continue disappointing as China’s growth weakens further. This will lead to tumbling EM currencies and outflows from high-yielding EM domestic bonds. Chart I-6What Drive EM Currencies Within an EM local currency bond portfolio, our recommended overweights are Mexico, Brazil, Chile, Russia, central Europe, Thailand and Korea. The list of our overweights and underweight across EM stocks, credit markets, local bonds and currencies is always published at the end of our reports. Bottom Line: Global asset allocation should treat EM stocks as part of a global equity portfolio. EM sovereign and corporate credit should be part of a global credit portfolio. In turn, EM local currency government bonds are a unique asset class with idiosyncratic features and a low correlation with other assets. Hence, their addition to any multi-asset class portfolio is recommended given an expectation of a positive return in the long run. A Make It Or Break It Juncture The rebound in various EM financial market segments is reaching a critical technical level. At that point, it will either reverse, or will break through and carry on the upward momentum for some time: EM share prices have troughed at their three-year moving averages but are now facing resistance at their 200-day moving averages (Chart I-7). Failure to break above their 200-day moving averages would signal higher risks of a major breakdown. Conversely, a decisive break above their 200-day moving averages would suggest that the recent rebound has much farther to go. Our Risk-on versus Safe-Haven currency ratio has found support at its 6-year moving average but is now facing resistance at its 200-day moving average (Chart I-8, top panel). This ratio is highly correlated with EM share prices, and its breakout or breakdown will be an important signal for the direction of EM, commodities and global cyclical assets in general (Chart I-8, bottom panel). Chart I-7EM Share Prices Are Between Support And Resistance Chart I-8This Currency Ratio Is Key To EM And Commodities Trend A relapse from this level would be a major bearish signal, as it would confirm the formation of a head-and-shoulders pattern in this currency ratio. The latter would entail a major breakdown. A number of EM currencies such as ZAR, MXN, KRW, TWD, MYR and CNY are at a critical juncture (Chart I-9). A breakout or failure to do so will entail a major move. Chart I-9AEM Exchange Rates Are At Make It Or Break It Juncture Chart I-9BEM Exchange Rates Are At Make It Or Break It Juncture Meanwhile, the BRL may be forming an inverted head-and-shoulders pattern (Chart I-10). Hence, continuous BRL strength would signal rising odds of an extension to the rally in Brazilian markets. Chart I-10The Brazilian Real: An Inverted Head-And-Shoulder? Finally, industrial metals prices have failed to rebound and appear to be forming a head-and-shoulders formation. This pattern foreshadows considerable downside from current levels (Chart I-11, top panel). In the meantime, oil prices have bounced off their long-term moving average and might have a bit more room to advance before hitting a major resistance between $65-$70 for Brent (Chart I-11, bottom panel). Bottom Line: Our fundamental view on EM risk assets remains negative due to our expectations of further weakness in China’s growth. However, we are monitoring various signals and indicators to gauge whether the latest rebound can last much longer, which would cause us to change our stance tactically. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Peru: Involuntary Monetary Tightening Peru’s central bank is tightly managing the country’s exchange rate. As a result, it has little control over local interest rates. The Impossible Trinity thesis stipulates that in a country that has an open capital account, the central bank can control either interest rates or the exchange rate, not both simultaneously. Provided Peru has an open capital account, its central bank can have tight control over either the exchange rate or interest rates. So long as the central bank focuses on exchange rate stability, local interest rates will fluctuate with its balance of payments (BoP). Therefore, Peru’s credit cycle and hence domestic demand swings and bank share prices are driven by BoP (Chart II-1). Negative BoP dynamics – shrinking inflow of U.S. dollars – causes local interest rates to move higher while a positive BoP leads to lower borrowing costs (Chart II-2). Chart II-1Commodities Prices & Bank Stocks Are Correlated Chart II-2Trade Balance Drives Interbank Rates We expect negative BoP dynamics for Peru going forward – metals prices will drop as China’s growth continues to decelerate, and EM countries will likely experience a bout of portfolio capital outflows. If Peru’s central bank continues to favor limited currency depreciation, its interbank rates will march higher. Chart II-3 illustrates that the pace of net foreign exchange reserves accumulation often negatively correlates with interbank rates and leads loan growth by around 12 months (Chart II-4). Chart II-3Peruvian Local Rates Have Risen Chart II-4Peru: Bank Loan Growth Will Relapse When the monetary authorities purchase foreign exchange reserves, they inject local currency excess reserves (liquidity) into the banking system. More plentiful banking system liquidity drives down interbank rates and allows banks to expand credit, boosting domestic demand. The reverse also holds true. The Peruvian central bank was able to mitigate upside in local rates amid the negative terms-of-trade shock in 2014-‘15 by conducting foreign currency swaps with banks. This swap led to an injection of local currency reserves into the system. Currently these swaps are being unwound and banks’ excess reserves are dwindling, putting upward pressure on local rates. Hence, the rise in interbank rates in the past 12 months has not only been due to negative terms of trade but also due to the expiration of foreign currency swaps. As metals prices drop and exports contraction deepens, the currency will come under selling pressure (Chart II-5). To prevent the currency from depreciating considerably, the central bank has to tighten liquidity, producing higher interbank rates. The latter bodes ill for domestic demand. Chart II-5Money Growth Is Contingent On Trade Bottom Line: We continue to underweight the Peruvian bourse because of its exposure to mining companies and banks. The former is at risk from falling industrial metals prices, while the latter will suffer from rising interbank rates. Within the mining sector, gold and silver stocks should outperform copper producers because we foresee more downside in industrial metals than precious metals prices. Andrija Vesic, Research Analyst andrijav@bcaresearch.com Footnotes Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Excess dollar liquidity is still deteriorating. The U.S. economy’s robustness suggests this trend will continue. Elevated EM-dollar debt and declining dollar liquidity point to lower global growth and a stronger dollar. Despite these cyclical forces, a tactical dollar correction is unfolding. Slowdowns do not evolve in straight lines, and deep investor pessimism is setting the stage for a temporary bout of positive surprises. DXY could correct to 93, EUR/USD could rebound to 1.17-1.18, and USD/CAD could fall to 1.27. Buy NOK/SEK. Feature Investment legend Stanley Druckenmiller often refers to the primacy of liquidity trends when making investment decisions. BCA is highly sympathetic to this view, as our DNA is rooted in the analysis of global liquidity trends. Under this lens, a peculiar trend has caught our attention: U.S. commercial and industrial (C&I) loans are currently accelerating, and easing lending standards point to further gains (Chart I-1). This is in sharp contrast with the 2015-2016 market riots and subsequent slowdown – an episode where banks tightened lending standards and loan growth decelerated sharply. While this represents a good omen for the U.S. economy, it is a dangerous evolution for the rest of the world. Chart I-1Resilient Corporate Sector Credit Growth Growing credit is good for the U.S. because it points to robust domestic demand. However, it is problematic for the rest of the world for two reasons. First, if U.S. credit growth is more robust today than in 2016, it also implies that the Federal Reserve is unlikely to pause its rate-hike campaign as much as it did back then. Thus, U.S. rates, the key determinant of the global cost of capital, may have additional upside as interest rate markets anticipate a year-long pause. This is not yet a problem for the U.S. economy, but it is one for rest of the world, which is exhibiting poorer growth trends. Second, U.S. credit growth is already outpacing the expansion of U.S. money supply by 7%, pointing towards a decline in dollar liquidity available for international financial markets. The reduction in the Fed’s balance sheet will contribute to a continuation of this trend. The fall in the amount of dollars available for the international financial system creates a brake on growth. Over the past 10 years, each time money supply growth fell below the loan uptake of the U.S. corporate sector, our Global Industrial Activity Nowcast, BCA’s Global Leading Economic Indicator, Korean exports, and global export prices all deteriorated considerably (Chart I-2). Chart I-2Deteriorating Excess Liquidity Hurts Global Growth The large dollar debt of emerging markets lies behind this relationship. If less dollars are available outside the U.S. financial system, EM borrowers have to bid more for these greenbacks, raising their cost of capital. Additionally, borrowers are likely to hoard any dollars they access in order to repay their liabilities instead of using these greenbacks to finance economic transactions. As Chart I-3 shows this problem is particularly acute today: relative to EM GDP and various measures of U.S. money supply, EM dollar debt stands at record highs, highlighting deep vulnerabilities if liquidity conditions deteriorate. Chart I-3The Sensitivity To Dollar Liquidity Stems From The Large Stock Of Dollar Debt The problem extends beyond the capacity of the U.S. economy to generate deposits in excess of non-bank liabilities. Despite a meaningful slowdown in non-U.S. industrial production, official reserves are contracting relative to global industrial activity (Chart I-4). This further suggests that the global economy is experiencing some form of liquidity crunch, where the growth of monetary aggregates is insufficient to support economic activity. This is a deflationary environment. Chart I-4High-Powered Money Lagging Sagging Activity Another factor is at play: We have often argued in these pages that carry trades are a key component of global liquidity, as they allocate funds from economies where savings are excessive (i.e. borrowing in funding currencies) to economies that need those savings to generate growth (i.e. carry currencies).1 This is why the performance of high-octane carry trades is often a very reliable leading indicator of global economic activity. However, as Chart I-5 demonstrates, EM carry trades funded in yen continue to perform execrably, a poor signal for global liquidity and growth. Chart I-5Underperforming Carry Trades Add To The Global Liquidity Woes The impact of the deterioration in dollar liquidity, in FX reserves growth and in carry trade liquidity is evident in EM monetary aggregates. EM M1 growth has sharply decelerated. Since decelerating EM money supply presages weaker growth, it also points to stronger counter cyclical currencies like the dollar and the yen, especially against the very growth-sensitive commodity currencies (Chart I-6). The dollar bull market is unlikely to be over this year. Chart I-6Ominious Signal From EM Money Supply This risk is reinforced by the tight inverse correlation between the dollar and U.S. commercial banks’ liquidity. When U.S. banks curtail their holdings of securities, a key source of dollar liquidity in international markets, a dollar rally follows (Chart I-7). Not only does last year’s fall in securities in bank assets point to a firming greenback, but if banks also expand their loan books they will also further curtail their securities holdings. Chart I-7Contracting Liquidity On U.S. Commercial Banks Balance Sheets Support The Dollar The much-higher real rates offered by U.S. Treasurys relative to other DM bonds magnifies these dollar positive trends (Chart I-8). Hence, not only will global growth and money quantity considerations prove tailwinds for the greenback, but so will more well-known drivers of exchange rates. Chart I-8Real Rates Differentials Still Favor The Dollar Bottom Line: The deterioration in global liquidity conditions continues to argue in favor of the dollar. Since U.S. credit growth is still managing to accelerate, the Fed is unlikely to pause on the rate-hike front for too long, implying that excess dollars will further vanish from the international financial system. Consequently, global monetary conditions will tighten again, and global growth has not hit its nadir this cycle. On a 9 to 12 month basis, the dollar will benefit in this environment, especially against cyclical commodity currencies. How Fast Can Investors Price In Bad News? Due to the tightening in global liquidity conditions, global growth has suffered. However, the global and U.S. stock-to-bond ratios, two financial market metrics finely tuned to global economic gyrations, have already fallen in line with our Global Economic and Financial Diffusion Index that tallies the improvement and deterioration among more than 100 key global variables (Chart I-9). This implies that asset prices already reflect much of the deterioration in the economic outlook. Chart I-9The Global Economy Is Soft, But Financial Markets Already Reflect This Reality The problem for bears is that economic cycles rarely play out in a straight line. Now that asset prices are incorporating poor expectations, any positive surprises, even if modest, could lift asset prices. And there is room for improvement in global economic surprises (Chart I-10), particularly as Sino-U.S. trade relations are improving, global financial conditions are easing and China is trying to manage its slowdown. In fact, China’s fiscal and monetary stimulus already points to a rebound in growth-sensitive currencies, and to a correction in the dollar (Chart I-11). Chart I-10Scope For A Rebound In Economic Surprises   Chart I-11Chinese Reflation Points To A Dollar Correction, Even If Only A Small One EM breadth confirms this message. Chart I-12 shows that the breadth of EM equities has not been this poor since early 2009. However, it has begun to rebound. Rebounds in EM breadth from such levels are historically associated with a weaker dollar, stronger commodity currencies and a weaker yen. Chart I-12Deep Oversold Conditions In EM Stocks Further Support The Case For A Dollar Correction Flows paint a similar picture. Global investors tend to buy Japanese bonds when global growth conditions deteriorate. Foreigners buying of Japanese fixed-income products now stands near record levels – something normally witnessed when credit spreads widen. However, positive economic surprises and the recent easing in global financial conditions suggest that these flows will reverse. When they do, the dollar will suffer (Chart I-13) and very pro-cyclical pairs like AUD/JPY will appreciate, even if only temporarily. Chart I-13Elevated Flows Into Japanese Bonds Suggest Overdone Pessimism, And Scope For A Dollar Correction It’s not just the commodity currencies that have upside: so does the euro. German bunds’ hedged yields have been rising relative to the U.S., which in recent years has often led to a rally in EUR/USD (Chart I-14). Chart I-14European Hedged Yields Imply A Euro Rebound How deep will this dollar down leg be? Our Intermediate-Term Timing Model suggests that the greenback’s weakness is likely to be limited. The dollar already trades below our fair-value estimate, but during corrective episodes it tends to trough at a 5% discount, implying that the DXY at 93 is a buy (Chart I-15). The euro, the dollar’s mirror image, could rebound to a roughly 5% overvaluation, implying that a countertrend move to 1.17-1.18 is also likely. Finally, the CAD may be able to rebound to USD/CAD 1.27. Chart I-15Gauging The Extent Of The Countertrend Moves At these levels, we would expect the countertrend moves to end. Ultimately, the aforementioned deterioration in global liquidity conditions means that positive surprises are likely to be transitory phenomena. Moreover, we doubt that Chinese stimulus, a key catalyst for a weaker dollar, will be very deep. Ultimately, our view remains that China is only trying to prevent a collapse of its economy and Beijing is extremely reluctant to stimulate enough to generate yet another boom – something needed to genuinely boost global growth if the Fed resumes its tightening campaign. Finally, while a trade deal between China and the U.S. is likely, investors should not get overly exuberant on its ramifications. Disagreements over intellectual property transfers will not be resolved anytime soon, and China remains the U.S.’s largest geopolitical challenger. Bottom Line: Global liquidity conditions may have deteriorated, suggesting a trough in global growth is not yet in the cards, but slowdowns do not evolve in straight lines. This means that oversold risk assets are likely to respond well to positive economic surprises. As a result, the countercyclical dollar will correct, probably to 93. The commodity currency complex should be the main beneficiary of this move, with downside in USD/CAD to 1.27. The euro could rebound toward 1.17-1.18. Buy NOK/SEK In June 29th, we closed our long NOK/SEK trade, expecting corrective action in this cross.  A serious selloff ensued, and we are now buying this pair again.2 First, NOK/SEK is very sensitive to oil prices (Chart I-16), and BCA’s Commodity and Energy service anticipates a rebound in oil prices this year on the back of tightening supply conditions. Chart I-16BCA's Oil View Points To A NOK/SEK Rebound Second, the Norwegian economy is outperforming Sweden’s. As Chart I-17 shows, the Norwegian LEI continues to rise relative to Sweden’s, which historically implies a much stronger NOK/SEK. Beyond the LEIs, Norway’s PMIs and economic surprises have not only rebounded, but are also outpacing Sweden’s equivalent metrics. The Norwegian consumer is also participating in the good times. The three-month moving average of employment growth, retail sales and consumer confidence are stronger in Norway than in Sweden. Chart I-17Norwegian Growth Is Superior To Sweden's Third, after a long period of underperformance, Norwegian core inflation stands above that of Sweden, pointing to a potentially more hawkish Norges Bank than Riksbank. Fourth, NOK/SEK trades at a 5% discount to its fair value implied by our Intermediate-Term Timing model. Historically, a rebound in this cross follows such discounts Chart I-18). Chart I-18The ITTM Highlights An Attractive Entry Point To Buy NOK/SEK Finally, NOK/SEK is at a technically attractive spot. Our momentum oscillator shows deeply oversold conditions in the pair (Chart I-19). However, momentum has begun to roll over, suggesting that a reversal of those oversold conditions is starting. Moreover, the uptrend that began in the first quarter of 2016 has been confirmed. Had NOK/SEK not rebounded from where it did, that uptrend would have been seriously challenged, with potential greater downside ahead. Chart I-19Favorable Technical Setup To Buy NOK/SEK Bottom Line: We are re-opening our long NOK/SEK trade. We avoided the serious correction in this pair at the end of last year, but rebounding oil prices, an outperforming Norwegian economy, a potentially more-hawkish Norges Bank, a favorable valuation backdrop and positive technical developments argue in favor of buying this cross. Set a stop at 1.037 and a target at 1.120.   Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Weekly Report, titled "Canaries In the Coal Mine Alert: EM/JPY Carry Trades", dated December 1, 2017, and Foreign Exchange Strategy Weekly Report, titled "Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth", dated December 15, 2017. Both are available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report, titled "What Is Good For China Doesn’t Always Help The World", dated June 29, 2018, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. has been mixed: Capacity utilization outperformed expectations, coming in at 78.7%. However, the Michigan Consumer Sentiment Index surprised to the downside, coming in at 90.7. Finally, existing home sales month-on-month grow also surprised negatively, coming in at 4.99 million. DXY has risen 0.2% this week. While we believe that DXY could experience some weakness in the next couple of months, we remain bullish on the DXY on a cyclical basis, as the strength in the U.S. economy will prompt the Fed to deliver more rate hikes than expected by market participants. Moreover, the sharp focus of Chinese policymakers on limiting indebtedness should continue to put downward pressure on global growth, helping the dollar in the process. Report Links: So Donald Trump Cares About Stocks, Eh? - January 9, 2019 Waiting For A Real Deal - December 7, 2018 2019 Key Views: The Xs And The Currency Market - December 7, 2018 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro has been negative: Both headline and core inflation came in line with expectations, coming in at 1.6% and 1% respectively. However, Markit Services PMI underperformed expectations, coming in at 50.8. Moreover, the Markit Manufacturing PMI also surprised negatively, coming in at 50.7. EUR/USD fell 0.4% this week. Thursday, ECB President Mario Draghi highlighted that downside risks to the European economy are building up. Overall, we agree with his assessment, and thus remain bearish on the euro on a cyclical basis. We believe that the Fed will eventually raise rates more than the market expects, widening the rate differentials between Europe and the U.S, which will hurt EUR/USD. Report Links: 2019 Key Views: The Xs And The Currency Market - December 7, 2018 Six Questions From The Road - November 16, 2018 Evaluating The ECB’s Options In December - November 6, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been negative: Import growth underperformed expectations, coming in at 1.9%. Moreover, driven by weak shipments to China, export growth also surprised to the downside, coming in at a 3.8% contraction. USD/JPY fell 0.1% this week. We remain bearish on the yen on a short-term basis, as the recent easing in global financial conditions and the improvement in sentiment towards risk assets will likely weigh on safe havens like the yen. Moreover, we believe that bond yields will start rising again. In light of the positive relationship between yields and USD/JPY, we remain bullish on this cross. Report Links: Yen Fireworks - January 4, 2019 2019 Key Views: The Xs And The Currency Market - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: Retail sales yearly growth and retail sales excluding fuel yearly growth underperformed expectations, coming in at 3% and 2.6%, respectively. Moreover, the claimant count change also surprised to the downside, coming in at 20.8 thousand. However, average hourly earnings growth also outperformed, coming in at 3.4%. GBP/USD has rose 1.5% this week, lifted by motion by MPs to delay the implementation of Article 50, and news that Jeremy Corbyn may be moving more clearly in favor of a new referendum if Labour takes hold of Westminster. We are closing our short EUR/GBP trade today, after reaching our target of 0.87. At this point, we think that plenty of good news have been discounted by the pound.  While it is true that GBP could go up on the back of positive political developments, we believe that the risk reward ratio of selling EUR/GBP is not as attractive anymore, especially if EUR/USD can rebound. That being said, we remain bullish on cable on a long-term basis due to its cheap valuation. Report Links: Deadlock In Westminster - January 18, 019 Six Questions From The Road - November 16, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in the Australia has been mixed: The participation rate surprised to the downside, coming in at 65.6%. However, the unemployment rate surprised positively, coming in at 5%. Moreover, the change in employment also outperformed expectations, coming in at 21.6 thousand, however, this improvement was driven by part-time positions, not full-time ones. AUD/USD has fallen by 1% this week. We remain bearish on the AUD versus the USD on a cyclical basis given that we expect that Chinese authorities will remain reluctant to over-stimulate their economy while global dollar liquidity deteriorates. Thus, in light of the tight economic links between Australia and  Chinese industrial activity, the Australian economy is likely to suffer, dragging the AUD down in the process. Report Links: Waiting For A Real Deal - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Policy Divergences Are Still The Name Of The Game - August 14, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand has been mixed: The Q4 New Zealand inflation on a year–over-year basis remains at 1.9%, slightly surprised to the upside. December business NZ PMI has increased to 55.1. December credit card spending year over year growth dropped to 4.5%. NZD/USD appreciated by 0.3% this week. On a structural basis, we are negative on the kiwi. The new government is looking to lower immigration, and implement an unemployment mandate. Both of these developments would likely lower the neutral rate of interest for the RBNZ, which would imply a lower NZD/USD. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 In Fall, Leaves Turn Red, The Dollar Turns Green - October 12, 2018 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada has been mixed: Consumer price index year over year growth in December surprised to the upside, coming in at 2.0%. Core inflation year over year measure also increased to 1.7%, from the previous 1.5%. Retail sales in November month on month growth is lower than expected, dropping to -0.9% from the previous 0.2% in October. Year-on-year growth hit levels not seen since 2012. USD/CAD is now trading above 1.3354, after a small rebound by 0.5% this week following weak data releases. We are bearish on Canadian dollar in the long run, but are bullish on a tactical basis. Financial condition will stay easy, as suggested by Stephen S. Poloz’s interview with Bloomberg this Wednesday. Given the recent trade tensions, housing market and oil price plunge, there is less urgency for BoC to push for higher rate at this moment. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 EUR/CHF has fallen 0.3% this week. We are bullish on this cross, given that the surge of the franc against the euro has caused a significant slowdown in Swiss inflation. The strong relationship between inflation and the currency means that any additional currency strength could severely impair the central bank’s objective of achieving 2% inflation. The SNB is very well aware of this developments, which means that it will likely intervene in the currency market in order to put a floor on EUR/CHF. Report Links: Waiting For A Real Deal - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Norges Bank kept the key interest rate unchanged at 0.75%. Overall, we remain bullish on USD/NOK on a cyclical basis, given that this cross is very sensitive to real rate differentials. We expect the Fed to continue hiking rates this year at a faster pace than the Norges Bank, a development which will widen rate differentials and provide a tailwind for USD/NOK. That being said, we are positive on NOK/SEK. Not only is this cross attractive from a technical perspective, but also the expected rise in oil prices should help the Norwegian economy outperform the Swedish one. Report Links: Waiting For A Real Deal - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 USD/SEK has risen by 0.6% this week. We are bullish on the krona on a long-term basis, as we believe that the Riksbank’s monetary policy is too accommodative considering the strong inflationary pressures brewing in the Scandinavian country. The cyclical outlook for the SEK remains poor, as the krona displays the highest sensitivity to the dollar’s strength of any G10 currencies. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights After this week’s drama, the Brexit political process remains extremely complex, but the probability of a hard Brexit is still below 10%. No easy compromise will come through as Brexit suffers a fundamental contradiction: balancing the desire to maximize British sovereignty versus minimizing the pain of leaving the common market. While cross-party talks will prove unfruitful, an extension of the Article 50 deadline is very likely. A new referendum is the most probable solution to the current impasse, but it will likely require a new election. The pound is cheap, but volatility will stay elevated. Buying the pound versus the euro on politically induced drawdowns remains the optimal strategy to gain exposure. Long-term GBP/USD calls are also attractive. The dollar cyclical bull market is intact, but the greenback correction is likely to deepen, especially against growth-sensitive currencies, the AUD in particular. Feature Theresa May’s soft Brexit deal has suffered the largest defeat since 1924 for a bill submitted by a sitting government. The proposed EU Withdrawal Agreement was voted down by 432 members of Parliament, including a whopping 118 members of the Conservative Party. This suggests that both hard Brexit and Bremain Tories voted against May. What lies at the heart of this historic collapse? The fundamental problem is that a soft Brexit is incompatible with the principal demand of Brexit voters: Sovereignty. Any relationship entailing continued access to EU institutions and markets will require two elements that reduce sovereignty: Paying an access fee and accepting the acquis communautaire of the EU without having a say in how it is formulated.1 We do not see how this impasse will be overcome. The financial community’s preferred option – that Prime Minister May breaks ranks and appeals to the Labour Party for a super-soft “Norway Plus” option – is a fantasy. First, the Labour Party smells blood and will likely oppose any deal. Second, a Norway Plus option would entail the highest loss of sovereignty imaginable, given that the U.K. would essentially pay full EU membership fees with no ability to influence the regulatory policies that London would have to abide by. There is also a debate as to whether London would be able to constrict immigration from the EU under that option over the long term, a key demand of Brexiters.2 Members of Parliament may also be getting cold feet due to the shifting poll numbers, which have slowly but steadily increased the gap between those who think that Brexit was the right choice and those who think it was the wrong choice to just under double digits (Chart I-1). This gap reveals that the U.K. public is having second thoughts, no doubt influenced by the incoherent process itself, but also by the combination of geopolitical factors that have changed the appeal of “going it alone.” Chart I-1A Serious Case Of Bregret First, the EU is no longer mired in an epic migration crisis, as it was in the months before the referendum (Chart I-2). Second, terrorist attacks committed by home-grown Islamic State adherents have abated in continental Europe, whereas they seemed to be a monthly affair ahead of the June 2016 vote. Third, the U.K.’s main ally, the United States, which is often cited as a key post-Brexit partner, has elected a president who is unpopular in the U.K. (Chart I-3), putting the “special relationship” in doubt. Chart I-2The Refugee Crisis Is Over   Since the fateful referendum in 2016, the world has become less stable. As such, voters in the U.K. are no doubt wondering whether leaving the EU really would entail greater sovereignty – or whether “going it alone” would mean having to take the fait accompli of large powers such as the U.S., China, and Russia – whose values they share even less than those of their fellow Europeans across the Channel. Sovereignty, in other words, does not operate under Newtonian laws, but is rather relative to one’s vantage point. In short, Brexit cannot be resolved merely with an extension of the negotiating period. Furthermore, our high-conviction view is that even if it were possible to pass the withdrawal agreement today by promising an even softer exit, the process will ultimately fail when, in two- or three-years’ time, Westminster pushes to vote on implementing such an arrangement. Investors should remember that there is another vote waiting after the transition period. In the meantime, we see the following options as a way to resolve the current impasse (Diagram I-1): Article 50 extension: The EU is on record stating that it would agree to extend the Article 50 deadline, currently set at March 29. The EU can do so with a unanimous vote of the EU Council. If there is one thing that the Euro Area crisis has taught investors, it is that deadlines are set in policy and legislation, not in stone. London can extend Article 50 with a simple legislative act, amending the March 29 deadline set in the EU Withdrawal Act (passed in June 2018). The EU is on record stating that it would be simple to extend the current negotiating period until July, when a new European Parliament (EP) would sit in its first session. Any extension beyond July would require U.K. members of European parliament (MEPs) to sit in the legislative body, as the country would remain part of the EU. This would mean that the U.K. would have to hold EP elections. We think this is a minor technicality. But it would be highly embarrassing for PM May if she had to organize EP elections a few months from now, especially if it galvanized the Bremain movement to turn out en masse and send Europhile MEPs to Strasbourg. The bigger question is what the extra time would accomplish. Given the size of the loss for the government on its Brexit bill, we think that both Labour Party members and Bremain supporters have been emboldened and will hold out for either a new election or a new referendum, or in case of Labour Party members, both.   New referendum: A new referendum would require an Article 50 extension. The rules for referendums are set out in the Political Parties, Elections, And Referendums Act of 2000. Westminster would have to pass legislation, which would then have to be considered by the Electoral Commission. The process would very likely go beyond March. The easiest path to a new referendum is through a Labour Party victory in an early election. For PM May to reverse her longstanding policy and call a new referendum, we would need another round of negotiations to fail. As such, it is difficult to see PM May concede to a second referendum, at least not until late in 2019.   A new election: Even though the January 16 vote of no confidence against the government failed, PM May could decide that she needs an early election. Why would she take this route? Because it could give her a political mandate with which to pursue renewed negotiations with the EU and her version of soft Brexit. Under the terms of the Fixed Term Parliaments Act, May would need two-thirds of all MPs in the House of Commons to approve a new election. Current polls show that the election would be too close to call (Chart I-4). We think May would stand a good chance of renewing her mandate by painting Opposition Leader Jeremy Corbyn as too left-leaning and as indecisive on Brexit. Chart I-4An Election May Not Provide A Clear Answer One option not on the table is another leadership challenge to PM May. She already survived the challenge in December and is therefore safe from a new one for 12 months. These rules could of course be changed or PM May could simply resign, but we do not expect either option. Simply put, a change of leadership in the Conservative Party is unlikely as hard Brexit supporters cannot get a majority of Tory MPs to support them, while soft Brexit MPs continue to support May. Could a no-deal Brexit occur? Technically, yes. According to the EU Withdrawal Act, the U.K. will leave the EU on March 29. As such, with no further legislative acts, the U.K. could “sleepwalk” into a hard Brexit. However, we believe that the probability of this is under 10%. There is not even close to a majority in Westminster for a hard Brexit. We estimate that, at most, only 10% of 650 MPs in the House of Commons favor a hard Brexit. As such, the government would certainly win a large majority for a piece of legislation that extends the deadline. And, according to the European Court of Justice ruling in December, London could stop the Article 50 process unilaterally, without EU approval. If the probability of hard Brexit is below 10%, isn’t the pound a screaming buy at this point? After all, if the probability of a major dislocation in the economic relationship between the U.K. and the continent is so low, it also means the probability that the Bank of England maintains as easy a monetary policy as its current one is minimal. Our low-conviction answer to this question is yes, the pound is indeed attractive. The reason why buying the pound is a low-conviction view is that one of the three alternative scenarios listed above could have mixed implications for the British economy as well as U.K. assets and the pound: A new election that produces a Labour government. Corbyn’s legislative agenda is the most left-leaning that Europe has seen since François Mitterrand. He is also on record stating that he would pursue his own negotiations with Brussels. Corbyn’s government would therefore prolong the uncertainty of Brexit while enacting an ambitious left-wing agenda. Ultimately, he may reverse both of these positions: succumbing to pressure to call a new referendum while moderating his economic policy. However, as was the case with Mitterrand in the early 1980s, it would require a deep market riot to force him to do so, which means that closing one’s eyes and buying the pound at these levels is not for risk-averse investors. Bottom Line: The political battle for Brexit is far from over. The risk of a hard Brexit has receded considerably to a less than 10% probability, but volatility will continue due to the inherent conflict between the desire to maximize British sovereignty and the objective to minimize economic pain. While cross-party talks are unlikely to yield any decisive changes, an extension of the Article 50 deadline is likely. A new referendum is the most probable end game of this saga, but it will probably require a new election. While the pound is an attractive long-term play, GBP pairs will continue to suffer from politically induced volatility. Investment Implications In September, we argued that the geopolitical risk premium in the GBP was too low in the face of the uncertainty ahead. Moreover, we recognized that the pound was cheap on many long-term metrics, limiting its downside potential. As a result, instead of shorting GBP outright, we recommended investors buy GBP-volatility, a view that panned out well for us. We closed this recommendation in mid-November, when Cabinet Ministers McVey, Raab, and Vara resigned from the government. Since that time, GBP volatility has receded as investors have increasingly agreed with our assessment that the probability of a hard Brexit is very low. However, the political reality in London continues to suggest that the GBP will trade in a volatile fashion, even if its long-term attractiveness remains alive. Hence, we continue to recommend investors use dips in the GBP to slowly begin moving capital into sterling. Practically, we have expressed this view by selling EUR/GBP. EUR/GBP trades toward the top end of its historical distribution (Chart I-5) and is likely to sell off violently on any whiff that a resolution of any kind is coming. Furthermore, since British interest rates are higher than in the euro area, investors are paid to wait while shorting this cross. Chart I-5EUR/GBP Is A Coiled Spring The pound is particularly cheap against the U.S. dollar (Chart I-6). As a result, buying GBP/USD offers the most attractive long-term potential. However, the intermediate-term hurdles for this position are greater than those present in selling EUR/GBP. First, long cable offers a negative carry of 1.89%, thus buying GBP/USD means that investors are paying to take on a lot of volatility. Second, our negative intermediate-term outlook for the global economy implies a strong dollar over the coming six to nine months, creating risks for GBP/USD holders while helping the profile of selling EUR/GBP (Chart I-7). Finally, since Brexit risks are weighing on the euro as well as the pound, if a hard Brexit were indeed to materialize, GBP would suffer much deeper losses against the dollar than against the euro. Chart I-6Lot Of Value In Cable   Chart I-7Our Strong Dollar Theme Favors Shorting EUR/GBP To Play Rebounds In Sterling This inherent conflict in GBP/USD between potentially large long-term gains but heightened short-term risk suggests that the best way to play cable is to buy long-term call options on this pair. As Chart I-8 shows, the implied volatility on 2-year GBP/USD options is elevated, but has been much higher in the past. Additionally, the implied volatility on these long-term options is abnormally low relative to that offered by 3-month options (Chart I-8, bottom panel), suggesting they are comparatively cheap. Thus, since the long-term outlook for cable is much more attractive than the short-term one, favoring long-term options as a vehicle to gain exposure to GBP/USD makes sense. It is a risky bet only deserving of a small portfolio allocation. Chart I-8Long-Term Call Options On Cable Are Attractive Bottom Line: Only investors with either long-term horizons or a deep capacity to handle volatility should begin garnering some exposure to the pound. Selling EUR/GBP when the pound weakens in response to political shocks remains the best vehicle to do so. While buying cable offers more attractive long-term potential returns than selling EUR/GBP, it is a riskier bet over a six- to nine-month horizon. Nonetheless, investors wanting to get some pound exposure via buying GBP/USD should allocate funds to 2-year GBP/USD call options. Short-Term Risks For The Greenback As we argued last week, continued downside in global growth as well as U.S. interest rate markets having already priced in a year-long pause by the Fed together point to continued upside for the dollar. However, we also highlighted that the dollar currently possesses significant tactical downside, especially against commodity currencies. Five reasons underpin our cautious tactically view: First, the dollar is currently over-owned. Both net speculative positions in the dollar and sentiment toward the DXY are near bullish extremes (Chart I-9). The dollar is a momentum currency, hence the progressive deterioration in our favored momentum signal for the greenback – the crossover of the one-month and six-month moving averages – suggests that the dollar could soon experience a momentum-induced liquidation. Chart I-9If Our Dollar Momentum Signal Turns Negative, There Is No Shortage Of USD Sellers Second, the most recent BAML Investor survey not only showed that investors are more pessimistic on global growth than at any point in the past decade, but also that a trade war was highest on the list of concerns. Today, the probability of a truce in Sino-U.S. trade relations is growing. A declining trade-war risk should temporarily support assets levered to global growth and hurt the defensive U.S. dollar. Moreover, a consequence of the warm-up between Beijing and Washington has been a weakening USD/CNY. Historically, a strengthening RMB is associated with rebounding commodity currencies (Chart I-10). Chart I-10A Strong CNY Points To Stronger Commodity Currencies Third, global growth could also temporarily positively surprise beaten-down expectations. Today, the highly mean-reverting Citi Economic Surprise Index is very stretched to the downside, suggesting scope for a reversal (Chart I-11). With Chinese fiscal stimulus building up, and the recent pick-up in the six-month Chinese credit impulse, a temporary bout of positive economic surprises is a growing risk for dollar bulls. Chart I-11There Is Scope For Economic Surprises To Rebound Fourth, our China Investment Strategy service’s Market-Based China Growth Indicator has rebounded (Chart I-12). This further reinforces the risk that global growth could positively surprise abysmal expectations. Chart I-12Markets Signalling A Pause In The Economic Slowdown Fifth, gold prices have rebounded significantly, implying an improvement in the global liquidity backdrop (Chart I-13). Since tightening global liquidity was a contributor to the deterioration in non-U.S. growth, rebounding gold prices also confirm that the slowdown in international economic activity may take a breather. Chart I-13Gold As A Liquidity Gauge Altogether, these five factors suggest that the corrective episode in the countercyclical dollar may deepen. Because Chinese reflation and a truce in Sino-U.S. tensions lie at the crux of the potential for positive economic surprises, the growth-sensitive currencies like the AUD, the CAD and EM currencies should outperform, especially vis-à-vis the yen. In this environment, Scandinavian currencies should also rise versus the euro. EUR/CHF is set to benefit from this backdrop. For the time being, we continue to view any weakness in the dollar as a correction, not the end of the bull market. Ultimately, the respite in the Chinese economy is likely to prove transitory. The six-month credit impulse is improving, but the 12-month credit impulse is not, even when fiscal stimulus is taken into account (Chart I-14). Since the noise-to-signal ratio is much greater in the six-month impulse than in the 12-month one, we believe that only once the longer-term credit impulse rebounds will Chinese economic activity form a durable bottom. Moreover, Chinese exports are beginning to suffer from a payback period after having been artificially supported by front-running ahead of the trade sanctions. As things stand today, the recent weakness in Chinese export growth looks set to worsen (Chart I-15). This will cause yet another shock to Chinese growth, one likely to percolate to domestic demand. Once it does, global industrial activity should soften again, creating a strong support for the dollar. Chart I-14China's 12-Month Credit Impulse Doesn't Point To An Imminent Economic Turnaround... Chart I-15 ...And Exports Are Set To Become A Significant Drag Bottom Line: Cyclically, fundamentals remain supportive for the greenback. However, the tactical picture shows that the dollar should correct further, especially against growth-sensitive currencies like the AUD, which could rally to 0.75. This view is because the dollar’s momentum is deteriorating sharply, the yuan is rising on the back of a growing likelihood of a trade truce, global economic surprises have room to brighten, China is implementing some reflationary efforts, and global liquidity is improving at the margin.   Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com   Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Footnotes 1 The acquis communautaire refers to the collection of accumulated legislation, legal acts, and judicial decisions that constitute the body of the EU law. 2 Proponents of the Norway Plus option point out that Article 112(1) of the European Economic Area (EEA) Agreement allows for restriction of movement of people within the area. However, these restrictions are intended to be used in times of “serious economic, societal or environmental difficulties.” It certainly appears to be an option for London to restrict EU migration, but it is not clear whether Europe would agree for this to be a permanent solution. Liechtenstein has been using Article 112 to impose quantitative limitations on immigration for decades, but that is because its tiny geographical area is recognized as a “specific situation” that justifies such restrictions.

Highlights After this week’s drama, the Brexit political process remains extremely complex, but the probability of a hard Brexit is still below 10%. No easy compromise will come through as Brexit suffers a fundamental contradiction: balancing the desire to maximize British sovereignty versus minimizing the pain of leaving the common market. While cross-party talks will prove unfruitful, an extension of the Article 50 deadline is very likely. A new referendum is the most probable solution to the current impasse, but it will likely require a new election. The pound is cheap, but volatility will stay elevated. Buying the pound versus the euro on politically induced drawdowns remains the optimal strategy to gain exposure. Long-term GBP/USD calls are also attractive. The dollar cyclical bull market is intact, but the greenback correction is likely to deepen, especially against growth-sensitive currencies, the AUD in particular. Feature Theresa May’s soft Brexit deal has suffered the largest defeat since 1924 for a bill submitted by a sitting government. The proposed EU Withdrawal Agreement was voted down by 432 members of Parliament, including a whopping 118 members of the Conservative Party. This suggests that both hard Brexit and Bremain Tories voted against May. What lies at the heart of this historic collapse? The fundamental problem is that a soft Brexit is incompatible with the principal demand of Brexit voters: Sovereignty. Any relationship entailing continued access to EU institutions and markets will require two elements that reduce sovereignty: Paying an access fee and accepting the acquis communautaire of the EU without having a say in how it is formulated.1   We do not see how this impasse will be overcome. The financial community’s preferred option – that Prime Minister May breaks ranks and appeals to the Labour Party for a super-soft “Norway Plus” option – is a fantasy. First, the Labour Party smells blood and will likely oppose any deal. Second, a Norway Plus option would entail the highest loss of sovereignty imaginable, given that the U.K. would essentially pay full EU membership fees with no ability to influence the regulatory policies that London would have to abide by. There is also a debate as to whether London would be able to constrict immigration from the EU under that option over the long term, a key demand of Brexiters.2  Members of Parliament may also be getting cold feet due to the shifting poll numbers, which have slowly but steadily increased the gap between those who think that Brexit was the right choice and those who think it was the wrong choice to just under double digits (Chart I-1). This gap reveals that the U.K. public is having second thoughts, no doubt influenced by the incoherent process itself, but also by the combination of geopolitical factors that have changed the appeal of “going it alone.” Chart I-1A Serious Case Of Bregret First, the EU is no longer mired in an epic migration crisis, as it was in the months before the referendum (Chart I-2). Second, terrorist attacks committed by home-grown Islamic State adherents have abated in continental Europe, whereas they seemed to be a monthly affair ahead of the June 2016 vote. Third, the U.K.’s main ally, the United States, which is often cited as a key post-Brexit partner, has elected a president who is unpopular in the U.K. (Chart I-3), putting the “special relationship” in doubt. Chart I-2The Refugee Crisis Is Over   Since the fateful referendum in 2016, the world has become less stable. As such, voters in the U.K. are no doubt wondering whether leaving the EU really would entail greater sovereignty – or whether “going it alone” would mean having to take the fait accompli of large powers such as the U.S., China, and Russia – whose values they share even less than those of their fellow Europeans across the Channel. Sovereignty, in other words, does not operate under Newtonian laws, but is rather relative to one’s vantage point.   In short, Brexit cannot be resolved merely with an extension of the negotiating period. Furthermore, our high-conviction view is that even if it were possible to pass the withdrawal agreement today by promising an even softer exit, the process will ultimately fail when, in two- or three-years’ time, Westminster pushes to vote on implementing such an arrangement. Investors should remember that there is another vote waiting after the transition period.  In the meantime, we see the following options as a way to resolve the current impasse (Diagram I-1): Article 50 extension: The EU is on record stating that it would agree to extend the Article 50 deadline, currently set at March 29. The EU can do so with a unanimous vote of the EU Council. If there is one thing that the Euro Area crisis has taught investors, it is that deadlines are set in policy and legislation, not in stone. London can extend Article 50 with a simple legislative act, amending the March 29 deadline set in the EU Withdrawal Act (passed in June 2018). The EU is on record stating that it would be simple to extend the current negotiating period until July, when a new European Parliament (EP) would sit in its first session. Any extension beyond July would require U.K. members of European parliament (MEPs) to sit in the legislative body, as the country would remain part of the EU. This would mean that the U.K. would have to hold EP elections. We think this is a minor technicality. But it would be highly embarrassing for PM May if she had to organize EP elections a few months from now, especially if it galvanized the Bremain movement to turn out en masse and send Europhile MEPs to Strasbourg. The bigger question is what the extra time would accomplish. Given the size of the loss for the government on its Brexit bill, we think that both Labour Party members and Bremain supporters have been emboldened and will hold out for either a new election or a new referendum, or in case of Labour Party members, both.    New referendum: A new referendum would require an Article 50 extension. The rules for referendums are set out in the Political Parties, Elections, And Referendums Act of 2000. Westminster would have to pass legislation, which would then have to be considered by the Electoral Commission. The process would very likely go beyond March. The easiest path to a new referendum is through a Labour Party victory in an early election. For PM May to reverse her longstanding policy and call a new referendum, we would need another round of negotiations to fail. As such, it is difficult to see PM May concede to a second referendum, at least not until late in 2019.   A new election: Even though the January 16 vote of no confidence against the government failed, PM May could decide that she needs an early election. Why would she take this route? Because it could give her a political mandate with which to pursue renewed negotiations with the EU and her version of soft Brexit. Under the terms of the Fixed Term Parliaments Act, May would need two-thirds of all MPs in the House of Commons to approve a new election. Current polls show that the election would be too close to call (Chart I-4). We think May would stand a good chance of renewing her mandate by painting Opposition Leader Jeremy Corbyn as too left-leaning and as indecisive on Brexit. Chart I-4An Election May Not Provide A Clear Answer One option not on the table is another leadership challenge to PM May. She already survived the challenge in December and is therefore safe from a new one for 12 months. These rules could of course be changed or PM May could simply resign, but we do not expect either option. Simply put, a change of leadership in the Conservative Party is unlikely as hard Brexit supporters cannot get a majority of Tory MPs to support them, while soft Brexit MPs continue to support May. Could a no-deal Brexit occur? Technically, yes. According to the EU Withdrawal Act, the U.K. will leave the EU on March 29. As such, with no further legislative acts, the U.K. could “sleepwalk” into a hard Brexit. However, we believe that the probability of this is under 10%. There is not even close to a majority in Westminster for a hard Brexit. We estimate that, at most, only 10% of 650 MPs in the House of Commons favor a hard Brexit. As such, the government would certainly win a large majority for a piece of legislation that extends the deadline. And, according to the European Court of Justice ruling in December, London could stop the Article 50 process unilaterally, without EU approval. If the probability of hard Brexit is below 10%, isn’t the pound a screaming buy at this point? After all, if the probability of a major dislocation in the economic relationship between the U.K. and the continent is so low, it also means the probability that the Bank of England maintains as easy a monetary policy as its current one is minimal. Our low-conviction answer to this question is yes, the pound is indeed attractive. The reason why buying the pound is a low-conviction view is that one of the three alternative scenarios listed above could have mixed implications for the British economy as well as U.K. assets and the pound: A new election that produces a Labour government. Corbyn’s legislative agenda is the most left-leaning that Europe has seen since François Mitterrand. He is also on record stating that he would pursue his own negotiations with Brussels. Corbyn’s government would therefore prolong the uncertainty of Brexit while enacting an ambitious left-wing agenda. Ultimately, he may reverse both of these positions: succumbing to pressure to call a new referendum while moderating his economic policy. However, as was the case with Mitterrand in the early 1980s, it would require a deep market riot to force him to do so, which means that closing one’s eyes and buying the pound at these levels is not for risk-averse investors. Bottom Line: The political battle for Brexit is far from over. The risk of a hard Brexit has receded considerably to a less than 10% probability, but volatility will continue due to the inherent conflict between the desire to maximize British sovereignty and the objective to minimize economic pain. While cross-party talks are unlikely to yield any decisive changes, an extension of the Article 50 deadline is likely. A new referendum is the most probable end game of this saga, but it will probably require a new election. While the pound is an attractive long-term play, GBP pairs will continue to suffer from politically induced volatility. Investment Implications In September, we argued that the geopolitical risk premium in the GBP was too low in the face of the uncertainty ahead. Moreover, we recognized that the pound was cheap on many long-term metrics, limiting its downside potential. As a result, instead of shorting GBP outright, we recommended investors buy GBP-volatility, a view that panned out well for us. We closed this recommendation in mid-November, when Cabinet Ministers McVey, Raab, and Vara resigned from the government. Since that time, GBP volatility has receded as investors have increasingly agreed with our assessment that the probability of a hard Brexit is very low. However, the political reality in London continues to suggest that the GBP will trade in a volatile fashion, even if its long-term attractiveness remains alive. Hence, we continue to recommend investors use dips in the GBP to slowly begin moving capital into sterling. Practically, we have expressed this view by selling EUR/GBP. EUR/GBP trades toward the top end of its historical distribution (Chart I-5) and is likely to sell off violently on any whiff that a resolution of any kind is coming. Furthermore, since British interest rates are higher than in the euro area, investors are paid to wait while shorting this cross. Chart I-5EUR/GBP Is A Coiled Spring The pound is particularly cheap against the U.S. dollar (Chart I-6). As a result, buying GBP/USD offers the most attractive long-term potential. However, the intermediate-term hurdles for this position are greater than those present in selling EUR/GBP. First, long cable offers a negative carry of 1.89%, thus buying GBP/USD means that investors are paying to take on a lot of volatility. Second, our negative intermediate-term outlook for the global economy implies a strong dollar over the coming six to nine months, creating risks for GBP/USD holders while helping the profile of selling EUR/GBP (Chart I-7). Finally, since Brexit risks are weighing on the euro as well as the pound, if a hard Brexit were indeed to materialize, GBP would suffer much deeper losses against the dollar than against the euro. Chart I-6Lot Of Value In Cable   Chart I-7Our Strong Dollar Theme Favors Shorting EUR/GBP To Play Rebounds In Sterling This inherent conflict in GBP/USD between potentially large long-term gains but heightened short-term risk suggests that the best way to play cable is to buy long-term call options on this pair. As Chart I-8 shows, the implied volatility on 2-year GBP/USD options is elevated, but has been much higher in the past. Additionally, the implied volatility on these long-term options is abnormally low relative to that offered by 3-month options (Chart I-8, bottom panel), suggesting they are comparatively cheap. Thus, since the long-term outlook for cable is much more attractive than the short-term one, favoring long-term options as a vehicle to gain exposure to GBP/USD makes sense. It is a risky bet only deserving of a small portfolio allocation. Chart I-8Long-Term Call Options On Cable Are Attractive Bottom Line: Only investors with either long-term horizons or a deep capacity to handle volatility should begin garnering some exposure to the pound. Selling EUR/GBP when the pound weakens in response to political shocks remains the best vehicle to do so. While buying cable offers more attractive long-term potential returns than selling EUR/GBP, it is a riskier bet over a six- to nine-month horizon. Nonetheless, investors wanting to get some pound exposure via buying GBP/USD should allocate funds to 2-year GBP/USD call options. Short-Term Risks For The Greenback As we argued last week, continued downside in global growth as well as U.S. interest rate markets having already priced in a year-long pause by the Fed together point to continued upside for the dollar. However, we also highlighted that the dollar currently possesses significant tactical downside, especially against commodity currencies. Five reasons underpin our cautious tactically view: First, the dollar is currently over-owned. Both net speculative positions in the dollar and sentiment toward the DXY are near bullish extremes (Chart I-9). The dollar is a momentum currency, hence the progressive deterioration in our favored momentum signal for the greenback – the crossover of the one-month and six-month moving averages – suggests that the dollar could soon experience a momentum-induced liquidation. Chart I-9If Our Dollar Momentum Signal Turns Negative, There Is No Shortage Of USD Sellers Second, the most recent BAML Investor survey not only showed that investors are more pessimistic on global growth than at any point in the past decade, but also that a trade war was highest on the list of concerns. Today, the probability of a truce in Sino-U.S. trade relations is growing. A declining trade-war risk should temporarily support assets levered to global growth and hurt the defensive U.S. dollar. Moreover, a consequence of the warm-up between Beijing and Washington has been a weakening USD/CNY. Historically, a strengthening RMB is associated with rebounding commodity currencies (Chart I-10). Chart I-10A Strong CNY Points To Stronger Commodity Currencies Third, global growth could also temporarily positively surprise beaten-down expectations. Today, the highly mean-reverting Citi Economic Surprise Index is very stretched to the downside, suggesting scope for a reversal (Chart I-11). With Chinese fiscal stimulus building up, and the recent pick-up in the six-month Chinese credit impulse, a temporary bout of positive economic surprises is a growing risk for dollar bulls. Chart I-11There Is Scope For Economic Surprises To Rebound Fourth, our China Investment Strategy service’s Market-Based China Growth Indicator has rebounded (Chart I-12). This further reinforces the risk that global growth could positively surprise abysmal expectations. Chart I-12Markets Signalling A Pause In The Economic Slowdown Fifth, gold prices have rebounded significantly, implying an improvement in the global liquidity backdrop (Chart I-13). Since tightening global liquidity was a contributor to the deterioration in non-U.S. growth, rebounding gold prices also confirm that the slowdown in international economic activity may take a breather. Chart I-13Gold As A Liquidity Gauge Altogether, these five factors suggest that the corrective episode in the countercyclical dollar may deepen. Because Chinese reflation and a truce in Sino-U.S. tensions lie at the crux of the potential for positive economic surprises, the growth-sensitive currencies like the AUD, the CAD and EM currencies should outperform, especially vis-à-vis the yen. In this environment, Scandinavian currencies should also rise versus the euro. EUR/CHF is set to benefit from this backdrop. For the time being, we continue to view any weakness in the dollar as a correction, not the end of the bull market. Ultimately, the respite in the Chinese economy is likely to prove transitory. The six-month credit impulse is improving, but the 12-month credit impulse is not, even when fiscal stimulus is taken into account (Chart I-14). Since the noise-to-signal ratio is much greater in the six-month impulse than in the 12-month one, we believe that only once the longer-term credit impulse rebounds will Chinese economic activity form a durable bottom. Moreover, Chinese exports are beginning to suffer from a payback period after having been artificially supported by front-running ahead of the trade sanctions. As things stand today, the recent weakness in Chinese export growth looks set to worsen (Chart I-15). This will cause yet another shock to Chinese growth, one likely to percolate to domestic demand. Once it does, global industrial activity should soften again, creating a strong support for the dollar. Chart I-14China's 12-Month Credit Impulse Doesn't Point To An Imminent Economic Turnaround... Chart I-15 ...And Exports Are Set To Become A Significant Drag Bottom Line: Cyclically, fundamentals remain supportive for the greenback. However, the tactical picture shows that the dollar should correct further, especially against growth-sensitive currencies like the AUD, which could rally to 0.75. This view is because the dollar’s momentum is deteriorating sharply, the yuan is rising on the back of a growing likelihood of a trade truce, global economic surprises have room to brighten, China is implementing some reflationary efforts, and global liquidity is improving at the margin.   Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com   Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Footnotes 1 The acquis communautaire refers to the collection of accumulated legislation, legal acts, and judicial decisions that constitute the body of the EU law. 2 Proponents of the Norway Plus option point out that Article 112(1) of the European Economic Area (EEA) Agreement allows for restriction of movement of people within the area. However, these restrictions are intended to be used in times of “serious economic, societal or environmental difficulties.” It certainly appears to be an option for London to restrict EU migration, but it is not clear whether Europe would agree for this to be a permanent solution. Liechtenstein has been using Article 112 to impose quantitative limitations on immigration for decades, but that is because its tiny geographical area is recognized as a “specific situation” that justifies such restrictions. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. has been mixed: Core inflation came in line with expectations at 2.2%. Meanwhile, initial jobless claims outperformed expectations, coming it at 216 thousand. Finally, the ISM Non-manufacturing survey also surprised negatively, coming in at 57.6. DXY has been flat since the beginning of the year. After falling through the end of 2018 and the start of 2019, the dollar has staged a small recovery, managing to be flat year to date. We believe that while the greenback could experience tactical weaknesses in the coming three months, our cyclical outlook for the dollar remains positive. After all, the Fed will be able to deliver more hikes than the markets currently anticipates, and global growth remains soggy. Report Links: So Donald Trump Cares About Stocks, Eh? - January 9, 2019 Waiting For A Real Deal - December 7, 2018 2019 Key Views: The Xs And The Currency Market - December 7, 2018 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro are has been negative: Industrial production yearly growth surprised negatively, coming in at a 3.3% contraction. Moreover, headline inflation also underperformed expectations, coming in at 1.6%. Finally, the Markit Composite PMI also surprised to the downside, coming in at 51.1. EUR/USD has been flat since the beginning of the year. We are positive on EUR/USD on a tactical basis, given that China could be experiencing a temporary rebound, and given that the fall in the dollar and bond yields at the end of 2018 improved financial conditions around the world. These factors should be positive for the euro over the next 3-months. Report Links: 2019 Key Views: The Xs And The Currency Market - December 7, 2018 Six Questions From The Road - November 16, 2018 Evaluating The ECB’s Options In December - November 6, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: Domestic Goods prices yearly growth underperformed expectations, coming in at a 1.5%. Moreover, overall household spending also underperformed expectations, coming in at a 0.6% contraction. However, bank lending yearly growth outperformed expectations, coming in at 2.4%. USD/JPY has fell at the beginning of the year but then managed to recover a bit. We are bearish on the yen on a tactical basis, given that the easing of financial conditions that started in late 2018 should continue to help risk assets. Consequently, safe havens like the yen should remain under pressure on a 3-month horizon. Report Links: Yen Fireworks - January 4, 2019 2019 Key Views: The Xs And The Currency Market - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: Core inflation came in above expectations, coming in at 1.9%. However, industrial production surprised negatively, coming in at a 1.5% contraction. Finally, retail price growth also surprised to the downside, coming in at 2.7%. GBP/USD has risen by 2% since the beginning of the year. The low probability of a hard Brexit will support the pound, however, as the British political situation remain extremely fluid, GBP will continue to experience elevated volatility. Nonetheless, we believe that the best vehicle to play the strength in the pound is to short EUR/GBP. This cross is now trading at the upper range of its historical distribution, and therefore, any good news coming out of Britain could make it sell off violently. Report Links: Six Questions From The Road - November 16, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia has been mixed: Retail sales month-on-month growth outperformed expectations, coming in at 0.4%. However, the trade balance for November also surprised negatively, coming in at 1.925 million. Finally, building permits month-on-month growth also surprised to the downside, coming in at -9.1%. AUD/USD has risen by 2.6% since the beginning of the year. We are positive on the AUD on a tactical basis, given that the current fall in the dollar and yields have eased monetary conditions and have provided a reflationary force helping risk assets. Moreover, the warming in Sino-U.S. relations and the recent strength in the yuan is adding another tailwind behind growth sensitive currencies like the Aussie. That being said, we are still bearish on the AUD on a cyclical timeframe, as the dual forces of Chinese deleveraging and Fed tightening should resume later this year. Report Links: Waiting For A Real Deal - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Policy Divergences Are Still The Name Of The Game - August 14, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand has been negative: Gross domestic product yearly growth came in below expectations, coming in at 2.6%. Moreover, electronic card retail sales month on month growth declined further from last month to -2.3%. NZD/USD has risen by 1.1% since the beginning of the year. While we are positive on the kiwi on a 3-month basis, as Chinese growth has started to rebound temporarily and global financial conditions have eased, we nonetheless prefer the AUD to the kiwi over this timeframe. That being said, the NZD will most likely depreciate against the dollar on a cyclical timeframe, as both the Fed and China reinitiate their tightening campaigns. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 In Fall, Leaves Turn Red, The Dollar Turns Green - October 12, 2018 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada has been positive: Seasonally adjusted housing starts growth came in above expectations, coming in at 213 thousand. Moreover, the unemployment rate surprised positively, coming in at 5.6%. Finally, the net change in employment also surprised to the upside, coming in at 9.3 thousand. USD/CAD has plunged by 2.5% since the beginning of the year. We are bullish on the CAD on a tactical basis, as oil prices should continue to rise on the back of tighter supply from OPEC. Moreover, the fall in yields which had led to easier financial conditions should continue to put upward pressure on commodity currencies like the Canadian dollar, a currency that very much enjoy falling risk-asset volatility. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been mixed: Headline inflation underperformed expectations, coming in at 0.7%. Moreover, the KOF leading indicator also surprised to the downside, coming in at 96.3. However, the SVME Purchasing Manager’s Index outperformed expectations, coming in at 57.8. EUR/CHF has risen 0.5% since the beginning of the year. We are bullish on EUR/CHF as global financial conditions are easing. Moreover, disappointing Swiss inflation and economic data highlight that the SNB remain unable to achieve its target. To achieve growing prices, Switzerland will need a weaker currency. Therefore, the SNB will pull all the necessary levers to put a natural floor under this cross. Report Links: Waiting For A Real Deal - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway has been positive: Headline inflation outperformed expectations, coming in at 3.5%. Moreover, core inflation also surprised positively, coming in at 2.1%. Finally, retail sales growth also surprised to the upside, coming in at 0.9%. USD/NOK has fallen by 1.3% since the beginning of the year. We are bearish on USD/NOK on a tactical time horizon, as global financial conditions are easing while oil prices are also rising. Report Links: Waiting For A Real Deal - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden has been mixed: Consumer confidence underperformed expectations, coming in at 96.4. However, retail sales month-on-month growth outperformed expectations, coming in at 0.8%. Finally, headline inflation came in line with expectations, coming in at 2%. USD/SEK has risen by 1.6% since the beginning of the year. On a long-term basis, we like the SEK. Not only is the krona exceptionally cheap, but also, strong inflationary pressures in Sweden should eventually force the Riksbank to tighten monetary policy. Despite these structural positives for the SEK, the cyclical outlook is much more tenuous as this currency historically responds most poorly among G10 currencies to dollar strength. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades