Currencies

Special Report

Dear Client, Wednesday, we sent you a Special Report by our Global Investment Strategist, Peter Berezin titled: The Return of Vol, which fleshed out BCA's view on the recent volatility spike and the associated market selloff. BCA believes that markets are realizing that U.S. inflation is not forever dead. As such, market volatility is set to rise, even if global equities can make new highs. From an FX perspective, a rise in U.S. inflation, especially when accompanied by the kind of spending programs announced this week in Washington DC, could result in a period of strength for the U.S. dollar. Additionally, since financial markets tend to experience clusters of volatility, the recent bout of volatility can stay in place for a while. High volatility tends to be negative for carry trades, hence EM currencies could suffer this quarter. The Australian dollar and the euro could also decline under this scenario. However, the yen and CHF may experience upside, but mostly against other currencies than the greenback. In this present report, we are updating our views on the G10 central banks. Best regards, Mathieu Savary Feature In our Special Report published last summer titled "Who Hikes Next?" we examined which of the G10 central banks would be next to join the Federal Reserve on its tightening path.1 Seven months later, we now know that the Bank of Canada and, to a lesser extent, the Bank of England, were respective second and third to begin raising their own policy rates. It is now time to revisit the topic and see which central banks are most likely to adjust their policy further. As Chart 1 shows, global goods prices have picked up steam, which has been translated in an ebbing of global deflationary forces. A few factors lie behind this improvement. First, China is not exporting deflation around the world anymore because the trade-weighted yuan has been stable and producer price inflation, which currently stands at 5%, has been in positive territory for 15 straight months. Second, thanks to ebullient global growth, global capacity utilization has grown significantly. Third, oil prices have climbed further. This development has been particularly meaningful as it has contributed to a significant pick-up in market-based inflation expectations. But as in every economic cycle, some risks are worth monitoring. As we have highlighted before, global money growth has slowed, Chinese monetary conditions have tightened meaningfully and Asian manufacturing activity has decelerated in a wide swath of countries. Even BCA's Global Capex Indicator (Chart 1, bottom panel), which flashed an unabashed green light last June, has begun to roll over. The recent market shakeup has also reminded investors that higher bond yields do have an impact on asset prices and economic growth. Despite these worries, we expect more central banks to join the fray this year and begin removing accommodation one way or another. Others will shy away, but they will guide markets toward expecting less monetary accommodation next year. Finally, some central banks will likely stand pat, and will leave their policy settings unchanged. Chart 2 illustrates where we think G10 central banks stand in their respective hiking cycles. Chart 1The Reasons Why Central Banks Are Tightening Chart 2G10 Central Banks Map The Hikers 1) The U.S. Chart 3U.S. The Federal Reserve will continue to tighten policy this year. To begin with, its communications on the topic have been extremely clear: the Federal Open Market Committee wants to increase interest rates three times in 2018. The Fed has good reasons for this hawkish stance. The gap between the real policy rate and the recent average of real GDP growth remains in stimulative territory (Chart 3). Meanwhile, U.S. financial conditions have rarely been easier, yet the economy is receiving a boost thanks to tax cuts and spending increases. There is, therefore, little mystery as to why survey data point to healthy GDP growth for the first half of 2018. In fact, the Atlanta Fed GDPnow model currently forecasts a growth rate of 4.0% for the first quarter of this year. This is an inflationary combination. It is not just growth conditions that are creating tailwinds for the Fed. Resource utilization is also elevated. According to the CBO, the U.S. output gap closed last year, and the unemployment rate not only stands at its lowest level in 17 years, but it is also well below equilibrium. We are already seeing the symptoms of this state of affairs: the employment cost index is growing at 2.6%/annum, its highest rate in three years; the growth of average hourly earnings just hit 2.9%/annum, and even core inflation is bottoming. These developments will give comfort to the Fed that hiking rates three times this year is the right strategy. The Hikers 2) Canada Chart 4Canada The Bank of Canada has already increased rates three times since we first explored this topic last summer. Like the Fed, the BoC has strong justification behind its hawkish stance. While the policy rate is not as stimulative as it was last year, capacity utilization has become much tighter (Chart 4). The unemployment rate is now back in line with its underlying equilibrium, and the BoC's Business Outlook Survey shows that the quantity and intensity of labor shortages have become elevated, which has historically led to higher wages. Additionally, the OECD's approximation of the output gap has closed, something also acknowledged by the BoC's models. Core inflation has begun to respond, rising to 1.5% in December. The current backdrop suggests this trend has further to go. Moreover, as exports to the U.S. represent 20% of Canada's GDP, the economic vigor south of the border will only translate into further inflationary pressures up north. Based on these factors, we expect the BoC to increase rates as much as the Fed in 2018. This view is not without risks. NAFTA negotiations remain rocky, and the uncertainty emanating from trade policy could hurt Canadian capex. Additionally, Canadian house prices remain 31% above fair value, Canadians sport a debt load of 170% of disposable income, and a growing array of macro-prudential measures are being implemented to slow the housing market. If this combination bites deeply - which remains to be seen - the BoC may be forced to, at least, pause its tightening policy faster than anticipated. Still Hiking? 3) The U.K. Chart 5U.K. On many metrics, the Bank of England looks set to hike again in 2018. There is no denying that British monetary policy remains extremely easy, as the gap between the real policy rate and real GDP growth is still in massively stimulative territory (Chart 5). Moreover, according to the OECD, the output gap stands at 0.4% of potential GDP. This observation seems to be corroborated by the fact that the unemployment rate remains nearly 1% below its equilibrium value. Adding credence to these assertions, U.K. core inflation spiked as high as 2.9% one month ago. However, make no mistake: the spike in inflation, while facilitated by tight supply conditions, is still mostly a consequence of the pass-through created by the pound's collapse in 2016. Because the rate of change of the pound has stabilized, the U.K.'s inflation rate will fall back to earth. Moreover, the outlook for British consumption is murky as the household savings rate has plunged to a mere 5.2% of disposable income, and debt growth is peaking. Corporations too have curtailed their borrowings, pointing to a weak capex outlook. While the MPC would like to hike once or twice this year, since a policy tightening is contingent on elevated inflation, the central bank may once again disappoint. For now, rate hikes look likely, but this may change if inflation decelerates sharply. In The Starting Blocs For 2018 4) Sweden Chart 6Sweden The December policy statement by the Riksbank highlighted that while the world's oldest central bank will reinvest the proceeds from redemptions and coupon payments from its large bond portfolio, it still expects to begin lifting its benchmark rate in the middle of 2018. This is not a minute too soon. Swedish monetary conditions are incredibly easy: Real interest rates are 6% below the average real GDP growth of the past three years (Chart 6). Moreover, Sweden is facing growing capacity constraints. The unemployment rate is nearly 1% below equilibrium, and according to the OECD, the output gap stands at 1.5% of GDP, the most positive number among the G10. The Riksbank's own capacity utilization measure - an excellent leading indicator of inflation - is at a 10-year high, pointing to further acceleration in a core inflation that is already very close to 2%. Additionally, Sweden is in the thralls of a massive real estate bubble, a byproduct of extremely loose monetary policy. The external environment will remain the main source of risk to this hawkish outlook. On the plus side, the European Central Bank has begun tapering its QE program and should end new purchases in September 2018. This limits how high the SEK can spike against the euro - the currency of Sweden's main trading partner - if the Riksbank tightens policy. However, Asian industrial production has slowed sharply, and Swedish PMIs are already buckling. Any deepening of the recent selloff in risk assets, especially if it spreads further into commodities, could cause Riksbank Governor Stefan Ingves to retreat to his dovish safe place. In The Starting Blocs For 2019... Or 2018 5) New Zealand Chart 7New Zealand The Reserve Banks of New Zealand is slated to hike rates by mid-2019. However, risks are growing that the RBNZ could be forced into an earlier first hike. Policy is currently massively accommodating as the real official cash rate stands nearly 4% below the average real GDP growth of the past three years (Chart 7). At 1.4%, core inflation remains below the RBNZ's target, but it is on a rising trend, especially as the Kiwi economy is beyond full employment and the OECD's measure for New Zealand's output gap is at 0.8% of potential GDP. Moreover, GDP growth remains robust, and terms of trade have been improving as dairy prices are still firm, thus a further overheating in this economy is likely. The political front could also give impetus for the RBNZ to hike earlier than it recently suggested. The Ardern government has proposed increasing the minimum wage to NZ$20/hour by 2021, starting in April 2018. This could fuel already improving wages, and thus fan inflation. This government also plans to increase fiscal spending, which tends to exacerbate inflationary pressures when an economy is at full capacity. Thus, inflationary risks in New Zealand are skewed to the upside. In The Starting Blocs For 2019... Or 2018 6) Norway Chart 8Norway The Norges Bank anticipates it will begin to increase rates toward the middle of 2018. The Norwegian central bank is facing an interesting cross current. On the one hand, when compared with other nations on the list, the Norwegian economy seems less ripe to withstand higher rates. To begin with, because Norwegian core inflation has fallen precipitously in recent years, the gap between real interest rates and the average real GDP growth of the past three years has narrowed considerably (Chart 8). Moreover, the unemployment rate remains 0.9% above equilibrium, while a more broad-based measure of slack, the output gap, stands at -1.6% of potential GDP, at least according to the OECD. Moreover, core inflation only hovers near a 1.2% annual pace and is expected to stay below 2.5% in the coming years. Despite these negatives for Norway, some important positives also exist, which explains the Norges Bank's optimism. The Norwegian economy did not go through much of a financial crisis this cycle; as a result, Norwegian banks are healthy, and the Norwegian money multiplier never imploded as it did in other G10 countries. Also, the Norwegian krone is very cheap, adding a further reflationary impulse beyond low rates. Moreover, Norwegian GDP growth has experienced a rebound on the back of rallying oil prices. However, oil prices are nearing the top end of our energy strategists' forecasts, suggesting this tailwind is receding. Altogether, this confluence of factors suggests that similar to the RBNZ, the Norges Bank is likely to hike rates in early 2019 or late 2018. 2019 Take Off 7) Australia Chart 9Australia The Reserve Bank of Australia may well begin increasing interest rates in early 2019. Many factors would argue that the RBA could in fact increase interest rates earlier. Even though it is less accommodative than Sweden's or New Zealand's, Australian monetary policy is quite easy as the gap between the real policy rate and the average real GDP growth rate of the past three years is well into negative territory (Chart 9). Additionally, core inflation has rebounded hitting 1.9% recently, while trimmed-mean CPI stands at 1.8%. Among additional positives, Australia's national income is growing at a robust 4.3% annual pace and job creation is brisk, with payrolls expanding at an impressive 3.6% rate on a yearly basis. These positives mask some stiff headwinds. Rapid national income growth will likely peter out. It was the result of the very large rebound in the RBA's commodity price index, however, this benchmark, which was growing at a 53% annual rate in February 2017, is now contracting at a 1% annual rate. Additionally, the OECD's measure for the Australian output gap stands at -1.5%. While it is true that the unemployment rate is below its equilibrium rate, the RBA's labor underutilization measure remains near 25-year highs. This explains why robust job creation is not being translated into wage gains, and suggests that the RBA is right to expect trimmed-mean inflation to durably be at 2-2.25% only by the end of 2019. Moreover, the recent strength in the AUD will also weigh on inflation going forward. Netting out pros and cons suggests that the most likely first hike by the RBA will be in early 2019. 2019 Take Off 8) Euro Area Chart 10Euro Area The European Central Bank has begun tapering its QE program, and if the global economy does not experience any meaningful relapse, the ECB will end new purchases this September. However, a rate hike is not in the offing this year. To begin with, the ECB's communications on the topic have been rather clear: At its latest press conference, President Mario Draghi once again rejected any possibility of a move this year, and even Jens Weidmann, the Bundesbank's head, acknowledged that the current market pricing - a hike in the summer of 2019 - is about right. While it is true that the ECB's monetary policy setting is still very accommodative, the unemployment rate remains 0.8% above equilibrium, and outside of Germany, labor underutilization is still high. Moreover, the OECD's estimate of the euro area's output gap still stands at -0.5% of potential GDP (Chart 10). Another hurdle is core CPI which remains well below the ECB's objective; in fact, after hitting 1.2% in May, inflation excluding food and energy has now relapsed to 0.9%. Peripheral nations are experiencing even weaker inflation readings. With the ECB's inflation forecast still well below target until 2020, a rate hike will have to wait until next year. The Laggards 9) Switzerland Chart 11Switzerland The Swiss National Bank remains firmly among the lagging central banks within the G10. Because inflation is still at only 0.7%, the gap between real interest rates and average real GDP growth of the past three years is among the least stimulative in the G10 (Chart 11). Corroborating this observation, loan growth has averaged a paltry 4% over the course of the past three years. Moreover, the Swiss economy is still replete with excess capacity. The unemployment rate may be a low 3%, but it still stands 1.3% above equilibrium, and Swiss wage growth remains very depressed. Moreover, the OECD pegs the Swiss output gap at -1.2% of potential GDP. On a PPP basis, the Swiss franc remains 5% overvalued against the euro, Swiss core inflation was only 0.7% in December, but better than the -1% posted in early 2016. The SNB is likely to officially abandon its foreign asset purchases this year. The Swiss economy has recovered from its doldrums of the past several years, and most importantly, the euro crisis is now fully in the rearview mirror. This means that safe-haven flows out of the euro area, which were pushing the CHF to nosebleed valuation levels, have dried up. In fact, this year's weakness in the franc versus the euro was not accompanied by much increases in SNB sight deposits, suggesting this depreciation has been organic and not manufactured in Bern and Zurich. However, until core CPI moves closer to 2% and Swiss wages pick up, the SNB will likely lag the ECB when it comes to actual interest rate increases amid fears that the Swiss franc will rebound and tighten policy again. A late 2019 or early 2020 hike remains the most likely scenario. The Laggards 10) Japan Chart 12Japan The Bank of Japan is also faraway from increasing policy rates. This is not because the Japanese economy is replete with excess slack. It is not. The active job openings-to-applicants ratio stands at a whopping 44-year high, the unemployment rate is 0.8% below equilibrium and the OECD's estimate of the output gap is in positive territory (Chart 12). However, despite this very inflationary backdrop, inflation excluding food and energy remains a paltry 0.3%/annum. The BoJ has rightfully identified moribund inflation expectations as the key to unlocking this mystery. Decades of deflation have created a deflationary mindset among Japanese economic agents. As a result, wages and inflation itself are not experiencing much of a lift. The BoJ is tackling this issue head on, and has made it clear that it will not abandon its yield curve control strategy until inflation is well above its 2% target. In the BoJ's view, an inflationary overshoot is now necessary to shock deflationary mentalities, which will be the keystone to let inflation take off in durable fashion. For now, the tight negative relationship between Japanese financial conditions and inflation suggests the BoJ will do its utmost to contain the yen, which would undermine the progress made in recent quarters. As such, we do not foresee any rate hikes until well into 2019. QQE is likely to be abandoned first, as in practice the BoJ has not hit its JGB purchases target since the first half of 2016. Investment Implications The dollar could experience a further lift in the first half of 2018. Investors plunked the greenback last year and in the opening weeks of 2018 because they had been focusing on the far future - a future in which the ECB hikes rates faster than the Fed. But the reality remains that this year and next, the Fed will lift interest rates much more than the ECB. This means the euro is vulnerable to a pullback as it is very expensive relative to differentials at the front end of the curve. The outlook for EUR/USD will improve again once we get closer to 2019. The CAD has niether much upside nor downside. Interest rate markets are pricing in as many interest rate increases as we are. The key for the CAD will once again be oil prices, but keep in mind that Brent prices are not far off from our energy strategists' target of US$67/bbl. The SEK and the NOK will likely experience upside versus the euro. Their central banks are also set to pull the trigger before the ECB. Moreover, these two currencies are very cheap. However, the ride is unlikely to be a smooth one. The budding slowdown in Asian manufacturing could generate temporary hiccups before yearend that will cause these extremely pro-cyclical currencies to swoon. The picture for the pound remains as murky as ever. On one hand, the BoE has begun to increase rates. However, this progress could run astray very easily if, as we expect, British inflation weakens anew. Moreover, Brexit negotiations with the rest of the EU are far from fully settled. Further, the trade-weighted pound is moving toward the top end of its post-Brexit range, making it highly vulnerable to even a modest disappointment. The Australian dollar is likely to experience a poor 2018, as the RBA is a long way from increasing interest rates, and on all the long-term metrics we track, the AUD is one of the most expensive currencies. A continuation of the recent spat of asset market volatility could prove to be unkind to the Aussie. The kiwi will likely outperform its antipodean brethren as we see upside risk for interest rates in New Zealand. Finally, Swiss and Japanese interest rates will remain near current levels for a few more years. This suggests that the Swiss franc and the yen have little durable upside this year. The same holds true for the first half of 2019. However, since Switzerland and Japan still sport hefty current account surpluses and supersized positive net international investment positions, the CHF and JPY will continue to behave as safe-haven currencies, rallying when global asset prices weaken. This means that since markets tend to experience volatility clusters, the recent bout of market volatility could continue, which will help both the Swiss franc and the yen over the coming weeks. This will be especially true if the CHF and JPY are bought against the EUR, AUD, CAD, and NZD. But beware: the yen is especially cheap, so any signs that inflation expectations of Japanese agents pick up could be associated with a sharp rally in the yen, as it will spell imminent doom for the BoJ's YCC strategy. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Special Report, titled "Who Hikes Next?", dated June 30, 2017, available at fes.bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades

Highlights This week's global equities sell-off spilled into oil markets, taking Brent and WTI down 2.7% and 3.7% as of Tuesday's close, in line with the S&P 500 decline, which began Friday. In line with our House view, we do not believe this will, in and of itself, deter the Fed from raising overnight rates four times this year. Nor do we believe oil-price weakness earlier this week reflects a breakdown in fundamentals. Any demand-dampening effects coming from a stronger USD in the wake of Fed rate hikes will have a muted effect on oil prices, provided OPEC 2.0 can maintain production discipline, and, critically, keep the Brent and WTI forward curves backwardated.1 Likewise, any demand stimulation coming from a weaker USD in the wake of a more measured Fed policy - e.g., two or three hikes - also will be muted by backwardation. Energy: Overweight. Fundamentally, we cannot see anything that warrants a change in our average-price forecast of $67 and $63/bbl for Brent and WTI this year. Our long Jul/18 WTI vs. short Dec/18 WTI calendar spread, put on in expectation of continued backwardation in oil forward curves, is up 81.5% since Nov 2/17, when we recommended it. Base Metals: Neutral. Base metals also were caught up in the equities sell-off, with spot copper trading ~ $3.15 - $3.20/lb on the COMEX. As with oil, we do not see the equities sell-off as a harbinger of a bearish shift in base metals fundamentals. Precious Metals: Neutral. Gold returns were relatively flat amid the equities sell-off with only a 0.6% loss. Our long gold portfolio hedge is up 7.9% since it was recommended on May 4/17. Ags/Softs: Underweight. China opened an anti-dumping and anti-subsidy investigation into U.S. sorghum imports, which the country's foreign ministry insisted was not related to recent U.S. tariffs on solar panels and washing machines. China accounts for ~ 80% of U.S. sorghum exports. Feature The global equity sell-off spilled into oil markets, with Brent and WTI prompt futures down 2.7% and 3.7% over the past week when the equity slide began (Chart of The Week). The proximate cause of the equities down leg appears to be the stronger-than-expected U.S. wage growth reported last week, suggesting inflationary pressures continue to build in the U.S. This prompted speculation the Fed would be inclined to increase the number of rate hikes it executes this year - going from a consensus view of three hikes to four - and that financial conditions would tighten. The equities sell-off this prompted then led to speculation the Fed would dial back the number of rate hikes it executes this year. We believe the Fed will look through the recent equity-market volatility, and will lift rates four times this year, in line with BCA's once-out-of-consensus House view. Chart of the WeekOil Prices Caught Up In Equities Sell-Off Chart 2Fundamentals Support Backwardation As far as oil markets are concerned, as long as the Brent and WTI forward curves remain backwardated (Chart 2), any impact from U.S. monetary policy on oil prices - chiefly through currency effects - will be muted. Demand-dampening effects coming from a stronger USD in the wake of Fed rate hikes will be dissipated in backwardated markets. Likewise, any demand stimulation coming from a weaker USD in the wake of fewer rate hikes policy at the Fed - e.g., two or three hikes - will be muted by backwardation. Fundamentals Dominate Oil-Price Evolution Chart 3Strong Fundamentals##BR##Force Inventories Lower Fundamentals point to continued tightening of crude oil markets in 1H18, the period we have the greatest visibility on: OPEC 2.0's production cuts are pretty much locked in to end-June, when the producer coalition again will meet to assess market conditions, and global demand growth will remain robust. Even with U.S. shale-oil output increasing, OECD inventories will continue to draw during this period (Chart 3). OPEC 2.0's goal of reducing OECD inventories to five-year average levels likely will be met late in 1H18 or early in 2H18, based on our global balances model. While it is possible OPEC 2.0 will extend its production cuts to year-end 2018, we don't believe it is likely. Voluntary production cuts by Russia and Gulf OPEC nations, combined with decline-curve losses in non-Gulf OPEC producers have removed ~ 1.4mm b/d from the market since January 2017. The bulk of these cuts have been made by KSA and Russia, which account for close to 1.0mm b/d of OPEC 2.0 production cuts. Based on our fundamentally driven econometric model, extending OPEC 2.0's cuts to year-end would lift average prices in 2018 from our current expectation of $67/bbl for Brent and $63/bbl for WTI to $71 and $67/bbl, respectively. Counterintuitively, we believe maintaining prices at this level for the entire year is not the desired outcome of OPEC 2.0's production-cutting strategy. Higher price levels will incentivize larger-than-expected shale-oil production gains than we currently are forecasting - ~ 1.0mm b/d in 2018 and 1.2mm b/d in 2019. In addition, they would breathe life into marginal production around the world, particularly in provinces where break-evens and services costs have fallen - e.g., the North Sea, Barents Sea and offshore Brazil. OPEC 2.0's Long Game KSA's and Russia's oil ministers, the leaders of OPEC 2.0, have stated they would prefer to see their coalition endure beyond end-2018, when their production-cutting deal expires. Be that as it may, they have yet to publicly articulate an agreed strategy for OPEC 2.0, either in terms of a preferred price level or price band, or a strategy that builds on the gains they've made in backwardating oil forward curves. Chart 4Stakes Are High For OPEC 2.0##BR##If No Post-2018 Strategy Emerges Russian Energy Minister Alexander Novak recently suggested a preferred range for prices of $50 to $60/bbl for Brent, the international crude-oil benchmark. In the short term, KSA likely prefers a higher price - between $60 and $70/bbl for Brent - to support the IPO of Saudi Aramco, which probably will occur later this year. As we near the end of 1H18, OPEC 2.0's leaders will have to provide some indication they are converging on a common production-management strategy. They will, we believe, have to begin behaving more like a central bank - i.e., providing the market forward guidance - and less like a loose alliance of like-minded producers lurching between stop-gap measures to support prices. Importantly, when they do provide such guidance, they will have to follow through on publicly stated goals, or risk losing credibility with markets. The stakes are fairly high. If, as we've modeled in our unconstrained case, OPEC 2.0 returns ~ 1.1 - 1.2 mm b/d of actual production cuts (ex-decline-curve losses) to the market beginning in 2H18, and U.S. shale and other producers respond to 2018's higher prices with aggressive production growth that carries through 2019, Brent and WTI prices could be pushing toward $40/bbl by the end of 2019 (Chart 4). Also note that if prices start to moderate in H2 2018, 2019 shale production growth may ultimately be less than the 1.2 MMb/d we have forecast, softening the decline in prices during 2019. Longer term, we believe KSA and Russia are aligned with Russia's preference, if for no reason other than to keep U.S. shale-oil production from realizing the run-away growth sustained higher prices almost surely would provoke. Such growth would accelerate the development of U.S. crude oil export capacity - already hovering around ~ 2mm b/d - and the competition for market share in markets OPEC 2.0 members are keen to defend. Higher prices also would improve the competitive position of non-hydrocarbon-based transportation - e.g., electric vehicles and hybrids - which works against OPEC 2.0's long-term goals. Backwardation Matters For OPEC 2.0 Price levels always will be an important policy variable for OPEC 2.0. Equally important, we believe, will be having a strategy that maintains a backwardated forward curve in the Brent and WTI markets. This is because OPEC 2.0 member states sell oil at spot-price levels - the highest point of a backwardated forward curve - while shale-oil producers hedge their revenues over a 1- to 2-year interval. Other than allowing prices to collapse once again, this is the most viable way of constraining U.S. shale production growth longer term. The steeper the backwardation in the WTI forward curve, in particular, the lower the average price level of the hedges producers are able to lock in when they hedge forward revenues. This translates directly into lower output, since producers cannot afford to field as many rigs at lower prices over the life of the hedge as they would be able to field at higher prices. The extent to which OPEC 2.0 can keep forward curves backwardated will determine the extent to which the USD influences oil prices, as well. Our recently concluded research reveals backwardation can mitigate FX effects on oil prices induced by U.S. monetary policy. There is a long-term equilibrium between the level of the USD's broad trade-weighted index (TWIB) and crude oil prices (Chart 5). Indeed, the USD TWIB is one of the key variables we use in our demand, supply and price models. A weak dollar spurs consumption - USD/bbl prices ex-U.S. are cheaper in local-currency terms, especially for fast-growing emerging markets - while production costs ex-U.S. are higher, which limits output growth at the margin. A stronger dollar restrains consumption and encourages production ex-U.S., at the margin. However, this long-term equilibrium is asymmetric. The strength of the correlation between the level of the USD and crude oil prices is such that as oil inventories fall - and backwardation becomes more pronounced - the USD becomes less important to the evolution of oil prices.2 This can be seen in the month-on-month (m-o-m) rolling correlation between prompt WTI futures and the USD TWIB plotted against the spread between 1st nearby WTI futures and 12th nearby WTI futures (Chart 6). Chart 5Long-Term Inverse Correlation##BR##Between USD TWIB And Crude Prices Chart 6Backwardated Forward Curves##BR##Limit USD's Effect On Oil Prices With the exception of the Global Financial Crisis (GFC), the higher the backwardation in crude oil forward curves, the smaller the USD-WTI correlation becomes.3 This suggests that, if OPEC 2.0 can maintain the backwardation in WTI and Brent in 2018, the correlation between crude oil prices and the USD TWIB likely will not go back to the large negative correlation typical of previous cycles. In other words, sustained backwardation will weaken the inverse relationship between WTI prices and the USD TWIB vs. the long-term average in place since 2000, which is roughly when oil prices became random-walking variables. We also looked at year-on-year change in U.S. commercial inventories vs. the USD-WTI prices correlation (Chart 7). Our analysis indicates that when inventories are building, the correlation between USD and WTI prices becomes negative, and when they are falling the correlation goes to zero or positive. This supports our earlier observation that when crude inventories fall, the USD becomes less important to the evolution of WTI prices, particularly spot prices. One more point that we should note: the inverse relationship between the USD and oil prices is a two-way street. In addition to a weaker USD helping to support higher oil prices, higher oil prices have also tended to weaken the USD by inflating the U.S. trade deficit through more expensive petroleum imports. However, over the past decade, the U.S. has reduced its volumes of petroleum imports by roughly 75%, from 12-13 MMB/d in 2007 to only 3-4 MM b/d today (Chart 8). Therefore, this feedback loop of higher oil prices weakening the USD, and lower oil prices strengthening the USD, is greatly reduced. Chart 7Tighter Inventories Limit##BR##USD's Effect On Oil Prices Chart 8Lower Imports Of Petroleum Help##BR##Insulate USD From Oil Price Moves The USD's influence on the evolution of oil prices essentially is an exogenous variable out of OPEC 2.0's control. To the extent it can minimize these effects by backwardating oil forward curves, the coalition reduces the impact of an essentially exogenous USD risk from its production-management strategy. Bottom Line: The Fed likely will view the equity sell-off as a transitory event, and proceed with four overnight-rate hikes this year, in line with our House view. Any read-through from Fed policy decisions to the USD TWIB will be muted by continued backwardation in crude oil forward curves. To the extent OPEC 2.0 can maintain backwardated forward oil curves, it reduces the impact of an essentially exogenous USD risk from its production-management strategy. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Analyst HugoB@bcaresearch.com 1 Jargon recap: OPEC 2.0 is the moniker we coined for the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia. Its historic production-cutting Agreement to remove 1.8mm b/d of production from the market - via a combination of outright cuts and decline-curve run-off - has largely held, despite wide-spread skepticism. "Backwardation" is a term of art in commodities describing a forward curve in which prompt-delivered crude oil trades at a higher price than crude delivered in the future - e.g., a year hence. This is a reflection of a tight market - i.e., refiners are willing to pay more for oil delivered tomorrow or next month than they are willing to pay for oil delivered next year. The opposite of a backwardated market is a "contango" market, another term of art. 2 Generally, falling commodity inventories put a premium on prompt-delivered supply. As inventories fall, there is less readily available supply in place to meet unexpected supply outages. Under such conditions, refiners will attempt to conserve inventory and bid for flowing supply more aggressively, either to replace consumption out of inventory or to keep inventories at safe levels so as to minimize stockout risks. Either way, prompt-delivered supply becomes more valuable than deferred supply. Backwardation reflects this dynamic by keeping prompt-delivered prices above prices for deferred delivery. Backwardation is the market's way of incentivizing storage holders to release inventory to the market. It also is the source of returns for long-only commodity index products. 3 The GFC of 2008 - 09 was a global liquidity event, in which correlations between most tradeable assets went to 1.0 as prices collapsed. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017

Highlights The end of the low volatility regime could mark a leadership change in global equities away from EM to DM. The near-term risk to our negative stance on EM risk assets is a scenario where Beijing allows RMB appreciation to head off major protectionist threats from the U.S. This could delay the U.S. dollar rally and support EM risk assets. The EM and commodities equity rallies might be facing formidable technical resistances. These equity segments have to break out these technical resistances decisively to confirm the sustainability of the bull market. Feature Global stocks have corrected, and volatility measures have surged. The low volatility regime appears to have come to a decisive end. Even though in the short run volatility measures could well decline after their steep surge of the past week, the cyclical outlook points to higher volatility relative to last year. Financial markets are likely to be re-priced to adjust to the end of this low-volatility period. This entails more stress, and an additional selloff in risk assets. Periods of low volatility historically sow the seeds of their own reversal. Investors tend to embrace high-risk strategies amid low volatility, and take on more leverage. As a result, market excesses and froth arise, increasing the market's vulnerability in the event of a reversal. The latest period of low volatility lasted for more than a year, and no doubt facilitated the build-up of froth and excesses in global financial markets. Chart I-1 illustrates that the aggregate volatility measure of various financial markets was at its lows of the past 12 years before surging in recent days. Chart I-1Rising Volatility Coincides With A U.S. Dollar Rally What does rising volatility mean for emerging market (EM) relative performance vis a vis developed markets (DM)? It is primarily contingent on the U.S. dollar. If the U.S. dollar rebounds along with the rise in volatility, as it has done in the past (Chart I-1), EM equities will commence underperforming DM bourses. If the U.S. dollar fails to rebound and drifts lower, EM stocks are likely to outperform DM equities. With respect to exchange rates, we believe one of the major driving forces for currencies is the relative growth trajectory. The latter can be approximated by relative equity market performance in local currency terms. Chart I-2 shows that U.S. share prices - of both large and small caps - have been outperforming their global counterparts in local currency terms. Persisting periods of outperformance of U.S. stocks versus their global peers eventually, albeit sometimes with a considerable time lag, instigates a stronger trade-weighted U.S. dollar. U.S. large-cap share prices are making new highs versus their global peers in local currency terms. This entails that the selloff in the broad trade-weighted dollar is at a very late stage. The dollar rebound is a missing trigger for EM relative equity outperformance to reverse. A Risk To Our View: The U.S. Dollar One risk to our negative stance on EM risk assets and our recommendation of underweighting EM versus DM is the continuation of the U.S. dollar selloff. The greenback has been trading very poorly despite jitters in global equity markets. The recent surge in the RMB versus the U.S. dollar may be indicative that the Chinese authorities are tolerating RMB appreciation to defuse a threat of major protectionist measures from the U.S. (Chart I-3). If the RMB continues to appreciate versus the greenback, Asian and other EM currencies will stay well supported, and EM outperformance will persist. Chart I-2U.S. Relative Equity Outperformance ##br##Warrants A Stronger Dollar Chart I-3Will Beijing Tolerate A Stronger RMB? We suspect that Chinese policymakers are reluctantly allowing the RMB to appreciate. Indeed, Chinese policymakers have been both vocal and public about their understanding of Japan's experience with deleveraging, and specifically the mistake made by Japanese policymakers of allowing the yen to appreciate in the early 1990s. As most know, deflationary forces stemming from the combined effects of deleveraging and currency appreciation set off a formidable deflationary adjustment in Japan in the 1990s. Given Japan's experience, our conjecture is that Chinese policymakers would rather opt for a stable-to-mildly weaker currency. This has been one of the cornerstones of our bullish bias on the U.S. dollar versus emerging Asian currencies. If China allows the RMB to appreciate further versus the U.S. dollar, a potential U.S. dollar rally versus EM currencies will be delayed. In turn, this will likely allow EM equity, currency and credit markets to outperform their DM peers. That said, a strong currency will add to the ongoing policy tightening in China. The cumulative impact of this policy tightening combined with currency appreciation will weigh on China's growth later this year. As such, our fundamental thesis on China-slowdown is still valid in the medium term. However, political interference in the currency markets could delay EM risk assets' response to it. Bottom Line: The near-term risk to our negative stance on EM risk assets is a scenario where Beijing allows further RMB appreciation to head off potentially major protectionist threats from the U.S. May 2006 Redux? The current riot in global stocks resembles the May 2006 correction to a certain extent. Back in the spring of 2006, then Federal Reserve Chairman Ben Bernanke had just taken the helm at the Fed. Global growth was strong, the U.S. dollar was selling off, and global share prices were surging and overbought. Chart I-4May 2006 And Now: EM Stocks, ##br##U.S. Bond Prices And U.S. Dollar In May-June 2006, markets sold off because of the then-prevailing narrative that Chairman Bernanke would be too dovish and would allow U.S. inflation to get out of hand. U.S. bond yields spiked, inflicting particular damage on EM. It seems that February 2018 may play out like May 2006. It will not be exactly the same, but there are enough similarities to draw parallels: Global growth is robust, inflationary pressures are accumulating. DM bond yields are rising and the greenback is selling off. The new Fed Chairman, Jerome Powell, just took over the reins at the Fed, and there are growing odds that U.S. inflation will soon begin to rise, justifying more Fed rate hikes. Chart I-4 illustrates the similarities between financial market dynamics in 2005-2006 and now. If we take 2006 as a guide, we can infer that the selloff is not yet over. In a matter of only five weeks EM share prices plunged by 25% in U.S. dollar terms, and the S&P 500 dropped by 7%. From a big-picture perspective, the May 2006 selloff was a sharp correction in a bull market that lasted for another year or so. Importantly, the 25% plunge in EM share prices that took place in 2006 occurred despite EM corporate profit growth expanding at a double-digit rate in 2006-'07. All that said, the 2006 selloff marked an important regime shift in the global economic landscape - the rate of U.S. growth peaked in the second quarter 2006, and began to decelerate. We believe that the current equity market riot will likely mark a bottom in U.S. inflation and the beginning of a slowdown in China. The U.S. Bond Market Selloff Is Not Over... Yet The selloff in the U.S./DM bond markets has not yet run its course: The U.S. inflation model - constructed by our colleagues in the Foreign Exchange Strategy service and based on U.S. capacity utilization and broad money supply - is pointing to higher inflation in the months ahead (Chart I-5). U.S. bond yields will likely move higher as forthcoming inflation prints validate our expectations for higher U.S. inflation. Fiscal stimulus amid robust growth and a tight labor market in the U.S. as well as record-high optimism among consumers and businesses have created fertile ground for rising inflation. The weak dollar of the past 12 months will also manifest in rising inflationary pressures. The U.S. bond term premium is still extremely low. Yet, budding uncertainty over inflation and the gradual end of QE programs in DM, will likely cause the U.S. bond term premium to rise from current depressed levels. Finally, simple DM bond markets technicals are still pointing to higher yields ahead (Chart I-6). Chart I-5U.S. Core Inflation Set To Rise Chart I-6U.S. Bond Yields: The Path ##br##Of Least Resistance Is Up Overall, the path of least resistance for DM bond yields is up. This will make EM local currency bond yields less attractive versus DM and especially versus U.S. Treasurys. Yield differentials between EM and the U.S. are already at a 10-year low (Chart I-7). Low risk premiums on EM local bonds and rising global financial market volatility suggest that flows to EM fixed income markets will slow over the course of this year. That said, near-term risks still remain due to the massive inflows that previously went into EM funds, and might not have been deployed yet. China's Tightening And Pending Slowdown It is not unusual for an equity market riot to begin with inflation and high-interest-rate fears and then culminate with a growth scare - with a rebound in between. 2018 may shape up to fit this pattern. Global equity markets seem to be immersed with inflation and policy tightening in the U.S. - and potentially in China. At some point, share prices could well stage a rebound but then relapse again as materially slower Chinese growth spills over to global trade.1 We have discussed our view on China and its spillover effect on EM in past reports, and will not reiterate our views and analysis here. We will only bring to clients' attention that manufacturing production volume in Asia has already been weakening for a couple of months (Chart I-8). Chart I-7EM Local Currency Bonds Over ##br##U.S. Treasurys: Yield Differential Chart I-8Asia's Manufacturing ##br##Production Growth Is Slowing Leadership changes in the equity markets occur amid selloffs. Hence, it is reasonable to expect a leadership shift within global equity market sectors and countries as well as currency markets. One major equity leadership shift could be that EM begins underperforming DM. A combination of rising U.S. inflation and bond yields and a slowdown in China are negative for EM financial markets, especially relative to DM ones. Reading Markets' Tea Leaves It remains to be seen how much further this selloff in global equities will last and whether this is the beginning of a major downtrend in EM risk assets. It is impossible to have perfect foresight. To help investors in their portfolio decisions, we combine our fundamental analysis with tools that assist us in forecasting business cycles as well as various chart patterns that may be indicative of the market's potential trajectory. The following charts illustrate that the EM and commodities equity rally may be facing formidable technical resistance. These equity markets have to break out decisively through these technical resistance lines to confirm the sustainability of the bull market. Global energy stocks have corrected after reaching their long-term moving average (Chart I-9, top panel). The latter served as a floor in the 2008 crash. It was a key technical level in the 2014-'15 bear market that did not hold up and was followed by a collapse in crude prices. Similarly, global steel stocks are exhibiting the same pattern (Chart I-9, bottom panel). Relative performance of emerging Asian share prices versus the global equity benchmark is also at a similar critical juncture (Chart I-10, top panel). Chart I-9Global Energy And Steel Stocks: ##br##A Technical Resistance Chart I-10Select EM Equity Markets ##br##Are Facing A Critical Test Finally, Brazilian share prices in U.S. dollar terms have also reached a crucial technical threshold (Chart I-10, bottom panel). Bottom Line: Share prices of a few equity sectors and markets that are imperative to the EM equity outlook are at important technical junctures. Failure to break above these technical resistance lines will corroborate our negative stance on EM/China growth and related financial markets. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 We elaborated the relationship between China/EM and DM growth in November 29, 2017 Emerging Markets Strategy Weekly Report, the link is available on page 12. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Global equities are technically overbought, making them highly vulnerable to a correction. The cyclical picture for stocks still looks good, thanks to strong economic growth and rising corporate profits, but the recent spike in bond yields is becoming a headwind. Valuations are highly stretched, particularly in the U.S. This points to subpar long-term returns. On balance, we recommend staying overweight global equities. However, investors should consider buying some insurance against a market selloff. The VIX has probably bottomed for this cycle and high-yield spreads are unlikely to move much lower. This makes long volatility and short credit positions attractive hedges. Going short AUD/JPY is also an appealing hedge, given the yen's defensive characteristics and the Aussie dollar's vulnerability to slower Chinese growth. We were stopped out of our long global industrials versus utilities trade for a gain of 12%. We are also raising our stop on our short fed funds futures trade to 70 bps. Feature A Cloudy Picture As a rule of thumb, technical factors drive stocks over short-term horizons of one-to-three months, business cycle developments and financial conditions drive stocks over horizons of one-to-two years, and valuations drive stocks over ultra long-term horizons of five years and beyond. Occasionally, all three sets of signals line up in the same direction. In March 2009, the combination of bombed-out sentiment, cheap valuations, green shoots in the economy, and the expansion of the Fed's QE program all aligned to mark the beginning of a powerful bull market in stocks. Unfortunately, today the calculus is not so simple. Stocks Are Technically Overbought Technically, the stock market has gotten ahead of itself. The S&P 500 Relative Strength Index hit a record high earlier this week, while our Technical Indicator reached a post-recession high (Chart 1). The S&P has now gone 310 days without a 3% drawdown and 402 days without a 5% drawdown - both records (Chart 2). Chart 1U.S. Equities Are Technically Overbought Chart 2It's Been A Long Time Since U.S. Stocks Corrected Irrational exuberance is back. Our Composite Sentiment Indicator has jumped to the highest level since right before the 1987 crash (Chart 3). Retail investors are also flooding back into the market. Discount brokers such as E*TRADE and Ameritrade have seen a flurry of activity (Chart 4).The latest monthly survey conducted by the American Association of Individual Investors showed that respondents had the largest allocation to stocks since 2000 (Chart 5). Chart 3Equity Investors Are Mega-Bullish Chart 4Retail Investors Have Piled In (Part I) Chart 5Retail Investors Have Piled In (Part II) The Economy And Earnings Still Paint A Bullish Backdrop Chart 6Economic Outlook Remains Solid In contrast to the ominous technical picture, the cyclical outlook for stocks looks reasonably solid (Chart 6). The Citigroup Economic Surprise Index for major advanced economies has risen to near record-high levels. Goldman's Global Current Activity Indicator stands close to a cycle high of 5%, up from 2.2% at the start of 2016. Our Global Leading Indicator has decelerated somewhat, but is still pointing to above-trend growth this year. Growth in the euro area remains strong. The economy grew by 2.5% in 2017, the fastest pace since 2007. U.S. growth is gathering steam. Real private final demand increased by 4.6% in Q4. The Atlanta Fed's GDPNow model is signaling growth of 5.4% in the first quarter, while the New York Fed Staff Nowcast is pointing to a more plausible growth rate of 3.1%. Reflecting the strong economy, corporate profits are ripping higher. 45% of S&P 500 companies have reported 2017 Q4 results. 80% have beaten consensus EPS projections, above the long-term average of 69%. 82% have beaten revenue projections, which also exceeds the long-term average of 56%. The fact that earnings and revenue have surprised so strongly to the upside is all the more impressive given the sharp increase in EPS estimates over the past few months (Chart 7). Moreover, the improvement in earnings has been broad-based across sectors (Table 1). Chart 7Analysts Scramble To Revise 2018 Earnings Estimates Higher Table 1Estimated Earnings Growth For 2018 Financial Conditions Are Supportive, But Rising Bond Yields Are A Risk Financial and monetary conditions remain accommodative, as judged by an assortment of financial conditions indices (Chart 8). The global credit impulse has surged (Chart 9). Chart 8Financial Conditions Have Eased Chart 9Global Credit Impulse Is Positive The recent rapid ascent in global bond yields complicates matters. So far, much of the increase in yields has been driven by higher inflation expectations. This has kept real yields down. Indeed, real 2-year yields have actually declined in the euro area and Japan over the last several months. In absolute terms, yields are still low by historic standards (Chart 10). As my colleague Doug Peta, who heads our Global ETF Strategy service, has documented, rising bond yields pose a bigger problem for the economy and risk assets when they move into restrictive territory (Table 2). We are not there yet (Chart 11). Stronger global growth and diminished spare capacity have pushed up the pain threshold for when rising bond yields begin to bite. In the U.S., fiscal stimulus and a cheaper dollar have also caused the neutral rate to rise. Chart 10Yields Are Still Low ##br## By Historic Standards Table 2Aggregate Real S&P 500 Returns ##br## During Rate Cycle Phases From August 1961 Chart 11Rates Not Hurting ... Yet Nevertheless, equities often struggle to digest rapid increases in bond yields. Although the late 2016 episode stands out as an exception, stocks have typically floundered following an increase in global bond yields of around 50 bps (Table 3). The yield on the JP Morgan Global Government Bond index has risen by 27 bps since last autumn. If yields continue their swift ascent, stocks could come under pressure. Table 3What Happens When Bond Yields Spike? Valuation Concerns Chart 12Demanding U.S. Valuations Point To Low Long-Term Returns Valuations are not much use for timing the stock market, but they are the most important driver of returns over the long haul. Chart 12 shows the close correlation between the Shiller P/E ratio in the U.S. and the subsequent 10-year total return for stocks. Even though realized earnings growth tends to be higher following periods when the P/E ratio is elevated, this is more than offset by a lower dividend yield and the compression of P/E multiples. Today's Shiller P/E ratio of 34 presages subpar returns over the next decade. The picture is somewhat better outside the U.S. Our composite valuation measure - which combines trailing P/E, price-to-sales, price-to-book, Tobin's Q, and market capitalization-to-GDP - suggests that most stock markets outside the U.S. will see returns in the low-to-mid single-digit range over the next ten years (Appendix 1). Nevertheless, this is still well below the historic average return for these markets. What To Do? Our cyclical overweight in global equities has worked out well, and barring evidence that the global economy is tipping into recession, we intend to maintain this recommendation. Nevertheless, the discussion above suggests that stocks are vulnerable to a near-term correction and that long-term returns are likely to be lackluster at best. As such, it is sensible to take out some insurance against a market selloff. The question, as always, is how to guard against a drop in equity prices without suffering too much of a drag if global bourses continue to grind higher. We noted three weeks ago that today's equity bull market is starting to look increasingly like the one in the late 1990s.1 Back then, rising equity prices were accompanied by both higher volatility and wider credit spreads (Chart 13). History seems to be repeating itself. The VIX bottomed on November 24 at 8.56 and ended last week at 11.08, even as the S&P 500 hit another record high. Investors should consider buying volatility futures on any major dip in the VIX. Junk bonds have also underperformed equities year-to-date, which has benefited our long S&P 500/short high-yield credit recommendation. As we go to press, the Barclays high-yield total return index is flat for the year, while the S&P 500 has gained 5.7%. Given the deterioration in our Corporate Health Monitor, and the likelihood that rising inflation will keep Treasury yields in an uptrend, investors should consider hedging equity risk by shorting junk bonds. Chart 13Volatility Can Increase And Spreads Can Widen As Stock Prices Rise Chart 14Chinese Growth Is Decelerating Moderately Go Short AUD/JPY Chart 15Iron Ore Stockpiles Are Hitting New Highs In China Going short the Australian dollar versus the Japanese yen is also an appealing hedge against a broad-based retreat from risk assets. The yen is a highly defensive currency. Japan has a healthy current account surplus of 4% of GDP. Its accumulated foreign assets outstrip foreign liabilities by a whopping 65% of GDP. When Japanese investors get nervous about the world and start repatriating funds back home, the yen invariably strengthens. The Aussie dollar is highly levered to the Chinese economy. While we do not expect a steep deceleration in Chinese growth this year, we do think that growth will fall from last year's heady pace. This can already be seen in the deterioration in the Li Keqiang index (Chart 14). The growth rate of railway freight, one of the index's components, has fallen from above 20% in early 2017 to -1%. Crucially for Australia, iron ore stockpiles in Chinese ports are hitting record highs (Chart 15). Meanwhile, the Reserve Bank of Australia's commodity index has rolled over. The year-over-year change in the index has dropped from a high of 47% six months ago to -1%. Domestically, the output gap stands at 2% of GDP. Both core CPI inflation and wage growth remain subdued (Chart 16). The household saving rate has dropped to 3%, while debt levels have reached nosebleed levels (Chart 17). This will limit consumer spending. Business confidence has dipped recently, as has the PMI new orders index (Chart 18). Mining capex has been trending lower, falling from over 6% of GDP in 2012 to 2.1% of GDP in 2017. The Australian government expects mining capex to sink further to 1.3% of GDP in 2018 (Chart 19). All this will limit the RBA's ability to hike rates. Chart 16Australian Core CPI Inflation And Wage Growth Remain Subdued Chart 17Australian Household Debt At Unsustainable Levels Chart 18Australia: Business Confidence And Orders Have Dipped Chart 19Mining Capex To Fall Further From a valuation perspective, AUD/JPY currently trades at a 27% premium to its Purchasing Power Parity exchange rate, having traded at a discount of as much as 50% back in 2000 (Chart 20). Speculators are heavily short the yen right now. As my colleague Mathieu Savary has noted, this could supercharge any short covering rally.2 Higher asset market volatility should also weaken the Aussie dollar. Chart 21 shows that AUD/JPY tends to be inversely correlated with the CVIX, an index of currency volatility. Chart 20AUD/JPY Trading At A Premium Chart 21Higher Vol Will Weaken AUD With this in mind, we are opening a new tactical trade recommendation to go short AUD/JPY. As a housekeeping matter, we are closing our long AUD/NZD trade for a loss of 1.8%. We were also stopped out of our long global industrial stocks versus utilities trade for a gain of 12%. Lastly, we are raising our stop on our short fed funds futures trade to 70 bps. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "Will Bitcoin be Defanged," dated January 12, 2018, available at gis.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report, "Yen: QQE Is Dead! Long Live YCC!," dated January 12, 2018, available at fes.bcaresearch.com Appendix 1 Chart A1Long-Term Return Prospects Are Slightly Better Outside The U.S.Long-Term Return Prospects Are Slightly Better Outside The U.S.Long-Term Return Prospects Are Slightly Better Outside The U.S. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights The dollar seems to have entered a cyclical bear market, which suggests that EUR/USD is in a multi-year bull market. While the euro performs well in the late stages of the business cycle, it has moved ahead of long-term fundamentals. A correction is growing increasingly likely. The euro's rally has been a reflection of hope that the ECB will tighten policy in excess of the Fed's in the coming years. This leaves the euro vulnerable to short-term disappointments on both the inflation front and the global growth front. The trade-weighted pound has downside from current levels as the BoE will be handcuffed by a fall in inflation, courtesy of a diminishing pass-through. Feature Two weeks ago, we explored the confluence of forces facing the euro. We concluded that in all likelihood, the euro had embarked on a new cyclical bull market that could push EUR/USD well above 1.30 over the course of the coming few years. We also highlighted some tactical risks that were present for the euro.1 This week, we delve into how the cyclically positive outlook for the euro is interacting with the more cautious, short-term view, especially in the wake of the U.S. dollar's recent wave of weakness that has pushed the euro above 1.25. The probability of a correction has grown only further. This could represent a shorting opportunity for tactical players, as well as an occasion to deploy more funds into the euro for agents with a longer investment horizon. It's A Bull Market, But... The body of evidence is growing that the U.S. dollar has entered a bear market, which would support the view that the dollar's antithesis - the euro - has entered a bull market. To begin with, my colleague Harvinder Kalirai, who runs BCA's Daily Insights service, has noted that the dollar has been following an interesting pattern since the end of the Bretton Woods era: It tends to depreciate for roughly 10 years, and then rally for five to six years (Chart I-1). Admittedly, there is a small set of bull and bear markets here, but this begs the question: Was the 2011-2016 bull market the heyday for the dollar this decade? Chart I-1USD: Times Up? To answer this question, it helps to understand where we stand in the current business cycle. BCA believes that while a U.S. recession is not imminent, we are nonetheless entering the last two innings of this cycle. Interestingly, as Chart I-2 illustrates, the euro tends to appreciate during the last two years of U.S. economic upswings. This is because historically, European growth begins to outperform U.S. growth in the late stages of the economic cycle. This observation resonates with today's environment. Chart I-2The Euro Rallies Late In The Business Cycle There is a glaring exception to this phenomenon: the period from 1999 to 2000. However, we view this particular interval as rather exceptional. First, the euro had just entered into force, and was still untested. Second, the U.S. basic balance was in a large surplus as M&A waves and the tech bubble were sucking in capital from all over the world. Third, the U.S. was experiencing the apex of its peace dividend, resulting in fiscal surpluses that gave comfort to investors. Beyond the ebullience of U.S. tech stocks, the parallels with this era are limited. The tendency for the European economy to boom late into the cycle also has implications for monetary dynamics. We, as most commenters, have been puzzled by the euro's divorce from interest rate differentials, especially at the short end of the curve. Even indicators that historically have been extremely reliable such as the spread between the European and U.S. 1-year/1-year forward risk-free rate have lost their explanatory power. However, late into the cycle, the European economic boom tends to lift expectations of future European Central Bank policy tightening faster than these same expectations in the U.S. As a result, the European yield curve steepens in contrasts to that of the U.S. We built a simple three-factor model to capture these dynamics. These factors are: real 2-year yield differentials between the euro area and the U.S., to grab the effect of current policy; the euro area minus the U.S. 10/2-year yield curve slope, to incorporate changes in perception of how fast the ECB will hike in coming years compared to the Federal Reserve; and the price of copper relative to lumber, to capture how U.S. growth dynamics - as represented by the price of lumber - are evolving relative to the rest of the world, as represented by the price of copper. Chart I-3 shows the model's results. Over the long run, this model explains nearly 70% of EUR/USD's variations, and most importantly, the significance of the three factors is stable over various samples. Three points are worth noting: Chart I-3A 3-Factor Model To Explain The Euro First, the euro was very undervalued from 2015 to 2017. It was not as cheap as in 1985 or 2000, but the narrative behind the dollar's strength this cycle was the perception that the USD was the "cleanest dirty shirt." This is not the same optimism as what prevailed during former U.S. President Ronald Reagan's Imperial Cycle of the 1980s, or the New Economy boom / unipolar moment for the U.S. in the late 1990s. Second, the euro's fair value has stopped falling as global growth has caught up to the U.S., and as the European yield curve has steepened relative to the U.S. thanks to the reappraisal by investors of the future path of the ECB's terminal policy rate this cycle. Third, the euro is now trading at an 8% premium to its fair value. This last point raises the question of a euro correction. Are we seeing conditions fall into place for the euro to experience a pullback toward its fair value of roughly 1.15? A move to this level would bring the euro straight back into its 38-50% retracement levels, based on the low recorded in late 2016. Bottom Line: It appears as if the dollar has begun a cyclical bear market. As a corollary, this implies that the euro has begun a cyclical bull market that could last many years. The main reason relates to where we stand in the current business cycle: An ageing business cycle is associated with a stronger euro - a result of the euro area's economic outperformance toward the end of the cycle. Despite this positive, it would seem the euro has overshot fundamentals factors that try to capture these dynamics. ... The Correction Is Nigh Conditions are still too precarious to call for a correction in the euro, but some facts need to be kept in mind as they highlight growing short-term risk. Dollar Dynamics From a technical perspective, the dollar is much oversold. Last week we illustrated how our Capitulation Index was inching closer to a buy signal. The "buying" threshold was hit this week. Confirming this message, the Dollar's RSI and 13-week rate of change are also at levels consistent with a dollar rebound (Chart I-4). To be sure, many FX investors have become enthralled by the "twin deficit" narrative. Since 2011, when worries about a growing combined fiscal and current account deficit spike, this tends to represent dollar buying opportunities for the next three to six months (Chart I-5). Chart I-4Oversold Dollar Chart I-5Because The Narrative Is Scary Blood In The Street? When it comes to the twin deficit narrative, at this point it is a very nice-sounding story, but it still lacks substance. For one, while a growing U.S. economy tends to be associated with a growing current account deficit, the U.S. is increasingly morphing from an oil importer to an oil exporter. As Chart I-6 illustrates, net oil imports for the U.S. have collapsed from 13.5 million bbl/day in 2005 to 3.8 million today, as oil production recently hit a 47-year high. Matt Conlan, who runs BCA's Energy Sector Strategy service, anticipates that within the next two to three years the U.S could even become a net exporter of oil. Thus, the expansion of the current account deficit is not baked in the cake. The fiscal deficit may also not widen as much as many fears over the next year or two. As Chart I-7 illustrates, the gyrations in the U.S. 30-year swap spread have been linked to fluctuations in the velocity of money in the U.S. As banks faced the imposition of higher capital ratios, Dodd-Frank, rising supplementary leverage ratios, and so on, they decreased their participation in the swap market. As the supply of funds fell in that market, swap spreads collapsed, punishing the receivers of the 30-year swap rate. But recently, with the growing likelihood that the supplementary leverage ratio rules will be softened, banks are coming back to the market, and the swap spread is rising again. Banks are also easing their credit standards on most things from C&I loans to mortgages. This suggests credit growth could pick up further, lifting money velocity. Chart I-6A Support For The U.S. Current Account Chart I-7Money Velocity To Pick Up Why does this matter? Simply put, the rise in velocity portends to an acceleration in nominal GDP growth. Rising nominal expansion is historically associated with narrowing budget deficits. This cycle is a prime example. The main reason why the U.S. deficit fell from 8% of GDP to 3.5% of GDP this cycle is because activity recovered, which lifted government revenues and narrowed the deficit. To be clear, we do not want to sound overly sanguine. The chickens will come home to roost. If the budget deficit does not blow out as much as many fear over the next two years, it will catch up to these dire expectations once GDP growth slows. Euro Dynamics In a mirror image to the DXY, the euro's 13-week week rate of change and RSI oscillator are also flagging overbought conditions. But more interesting developments are happening that highlight the elevated correction risk for the euro. As Chart I-8 shows, the correlations between EUR/USD and the relative euro area/U.S. yield curve slope as well as the real interest rate gap tends to swing widely over time. Most interestingly, when the euro correlates closely with the relative yield curve slope and ignores real rate differentials, this tends to be followed by a reversal of the previously prevailing trend in the euro. This seems to tell us that when investors are more focused on the potential for an adjustment in relative policy between the euro area and the U.S. instead of current real rate differentials, they expose themselves to surprises - surprises that cause the trend to change. Today, the euro correlates massively with anticipated policy changes - not the current situation - highlighting the risk of a correction if anything dashes hopes of higher European rates in future. Chart I-8Euro: Future Versus Present In terms of potential culprits, inflation expectations rise to the top of the list. Since mid-2016, when euro area CPI swaps began to weaken relative to the U.S., this has typically been followed by a correction in EUR/USD (Chart I-9). Simply put, sagging relative inflation expectations prompt investors to question whether or not they should continue to anticipate a tightening by the ECB relative to the Fed in the years ahead. Additionally, EUR/USD has historically traded as a function of global export growth, reflecting the euro area's greater leverage to global trade than the U.S.'s. However, as Chart I-10 highlights, the euro has overshot the mark implied by global trade growth. Chart I-9Inflation Expectations Point To A Correction Chart I-10Euro Is Stronger Than Global Trade Warrants In of itself, this is a weak signal. After all, the decoupling can be solved by a rebound in global trade. However, the decline in manufacturing production evident across EM Asia suggests this will not be the case, as global trade is dominated by shipments of manufacturing goods (Chart I-11). If these waves were to affect Europe, it could spur a period where investors begin questioning the path for the ECB's policy rate. Some European indicators already highlight this risk. Sweden's economy is very sensitive to global trade growth, as exports represent nearly 50% of Sweden's economy. Moreover, Sweden exports a lot of intermediary goods to Europe. This place within the European supply chain suggests that if any weakness in global trade emerges, it is likely to be felt in Sweden before it is felt in the rest of Europe. Today, while European PMIs are still near record highs, Swedish Manufacturing PMI have been falling significantly after hitting 65 last year (Chart I-12, top panel). This suggests the first ripples of the manufacturing slowdown in Asia are hitting Europe's shores. Chart I-11A Headwind For Global Trade Chart I-12The Slowdown Will Come To Europe In the same vein, Switzerland is a large exporter of machinery and chemicals. Its exports are therefore also sensitive to the global manufacturing cycle. Swiss export orders have been nosediving in recent months, which has historically pointed to periods of vulnerability for EUR/USD (Chart I-12, bottom panel). Finally, as Chart I-13 shows, for the past year, rises in the FX market's implied volatility have been followed by periods of weaknesses in EUR/USD. This also suggests that at the very least, the euro will need to digest its recent strength for another while before rallying anew. At worst, a correction could emerge in the first quarter of 2018. Meanwhile, Chart I-14 illustrates that EUR/JPY could also suffer downside in the wake of a rise in currency implied volatility. We were stopped out of this trade for now, but it remains a high conviction all for the first half of 2018. Chart I-13Higher FX Vol: A Risk For EUR/USD... Chart I-14...And EUR/JPY Bottom Line: The time is nigh for a euro correction to begin. From the dollar's perspective, not only is it oversold, but stories of a 'twin deficit" tend to be associated with selling pressures hitting their paroxysm, at least on a three- to six-month basis. Meanwhile, the euro is not only overbought but is also trading in line with hopes for a rise in policy rates vis-à-vis the U.S. while ignoring the current situation in terms of real rate differentials - a situation that historically has only lasted so long without a reversal, even if temporary. Moreover, European inflation expectations are weakening and Asia's manufacturing cycle is slowing, heightening the risk that investors temporarily curtail their hopes for the ECB and move back to focusing on current real rate spreads. A Few Words On The Pound The Bank Of England is meeting next week. BoE Governor Mark Carney made some hawkish noise this week, highlighting that the impact of the Brexit shock is passing, and that the BoE can narrow its focus on inflation dynamics. This of course begs the question of what the outlook is for inflation dynamics. As Chart I-15 illustrates, inflation across a broad swath of components is likely to slow sharply in the coming months as the trade-weighted pound has stopped depreciating as sharply as it did in 2016. Thus, the pass-through from a lower exchange rate is beginning to dissipate. Moreover, in terms of growth, Brexit risk may have receded, but the British economy continues to face important hurdles. For one, real consumption, which constitutes 63% of the British economy, could decelerate further (Chart I-16). Real disposable income growth is negative and household confidence is declining. Additionally, the savings rate has no downside left, especially as household credit growth is beginning to weaken. The weakness in house prices, especially in London, will not dissipate anytime soon, as the RICS survey is still displays poor showings. Chart I-15U.K.: Less Pass-Through Chart I-16The British Consumer Is Feeling The Pinch On the capex front, the picture is not much brighter. Strength in the global economy along with weakness in the pound have lifted export growth. However, corporate investments have failed to follow. In fact, private credit growth is flagging anew (Chart I-17). The market is currently pricing in 36 basis points of interest rate hikes in the U.K. for 2018, with the first one anticipated in September. Rob Robis, our Chief Global Fixed Income Strategist, does not believe the current economic situation will let the BoE actually follow this lead. Carney's recent emphasis on inflation may actually turn out to be a double-edged sword: If today's inflationary strength justifies higher rate, tomorrow's anticipated weakness will not. Thus, a potentially hawkish BoE next week will probably have to be faded, not heeded. In terms of currency markets, the trade-weighted pound is testing the upper bound of its post-Brexit trading range (Chart I-18). The economics currently at play in the U.K. make it unlikely that it will be able to punch above this line yet, especially as the U.K.'s basic balance is once again dipping as FDI is drying out. Chart I-17Private Credit Growth Is Slowing Chart I-18GBP: Stuck In A Rut Bottom Line: British inflation is set to slow, and the economy remains on a weak footing. The BoE will find it difficult to tighten policy much this year. With the trade-weighted pound at the top end of its post-Brexit range, a correction is likely over the coming weeks. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, "The Unstoppable Euro?" dated January 19, 2018 available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S. data has been decent: Initial jobless claims declined to 230,000, while continuing jobless claims increased to 1.953 million; ISM Manufacturing index beat expectations of 58.8, coming in at 59.1; ISM Prices paid also beat expectations at 72.7; However, the employment subcomponent decelerated sharply; Chicago PMI beat expectations of 64.1, coming in at 65.7; While the Fed stayed pat in this week's FOMC monetary policy meeting, there is a 99% probability currently being priced in that New Chairman Powell will begin his leadership with a hike. This is in line with our own expectations. Report Links: A Cold Snap Doesn't Make A Winter - January 5, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 European data was mixed this week: Consumer confidence, service sentiment, business climate and overall economic sentiment all failed to meet expectations; 2017 Q4 GDP grew at a 2.6% annual pace, implying that the euro area's growth in 2017 once again beat that of the U.S.; German headline inflation came in at 1.4%, less than the expected 1.6%; German unemployment rate decreased to 5.4%, beating expectations; Overall European inflation (headline and core) both outperformed consensus at 1.3% and 1% respectively. However, PMIs remain strong. The overall sentiment on the euro remains very bullish. We are likely seeing the beginning of a protracted cycle of appreciation in the euro as markets align the ascent of the currency with its growth prospects. However, the relationship against the greenback may be blurred as the Fed is hiking faster than the ECB. Report Links: From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 The Unstoppable Euro? - January 19, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: The jobs/applicant ratio outperformed expectations, coming in at 1.59. This measure is now at 44 year-highs. Moreover, retail trade yearly growth outperformed expectations, coming in at 3.6%. It also increased from 2.1% the previous month. However, consumer confidence underperformed expectations, coming in at 44.7. Additionally, the unemployment rate also surprised negatively, coming in at 2.8%. It also increased from 2.7% the previous month. After falling precipitously last week, USD/JPY has been flat this week as Japanese policy makers increase purchases and talked down the yen. In the coming 3 months, we expect EUR/JPY to have significant downside, as financial conditions have tighten significantly in Europe relative to Japan. Moreover, rising volatility, particularly from such depressed levels will also weigh on this cross. Report Links: Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Riding The Wave: Momentum Strategies In Foreign Exchange Markets - December 8, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: Net lending to individuals monthly growth outperformed expectations, coming in at 5.2 billion pounds. This measure also increased from last month's 4.9 billion pound reading. Moreover, nationwide house price yearly growth also surprised to the upside, coming in at 3.2%. This measure also increased from 2.6% last month. However, mortgage approvals underperformed expectations, coming in at 61 thousand. Finally, manufacturing PMI underperformed expectations, coming in at 55.3. GBP/USD has rallied by roughly 0.6% this week. Overall, we expect the ability of the BoE to hike more than once this year to be limited, given that the sharp appreciation that the pound has experienced in recent months should weigh on inflation. This means that cable is unlikely to have much upside from here on. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Australian data this week surprised to the downside: NAB Business Confidence and Conditions came in lower than expected at 11 and 13 respectively; Headline CPI disappointed at 1.9% yoy, while the trimmed mean CPI also failed to perform as expected, coming in at 1.8%; Building permits contracted heavily in monthly terms at 20%, even contracting in yearly terms at a 5.5% rate; The RBA Commodity Index in SDR terms contracted by 0.6%, which was still better than the expected 8.9% contraction; These data support our view that substantial slack remains in the Australian economy. The RBA will need to consider the lackluster inflation figures at their next meeting, and are likely to maintain an easy policy setting this year. Report Links: From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand has been positive: The trade balance outperformed expectations, coming in at -2.840 billion. It also increased from -3.480 billion the previous month. Moreover, exports for December came in at 5.5 billion, increasing from the November reading of 4.61 billion. NZD/USD appreciated by 1.2% this week. Overall the kiwi has upside against the Australian dollar, given that a negative fiscal impulse and decreased investment will likely weigh on Australia's economic outlook. Moreover the NZD would be less sensitive than the AUD to a potential slowdown in Chinese industrial activity caused by the PBoC tightening. These factors will likely weigh on AUD/NZD. That being said, if a Chinese slowdown does occur, NZD/JPY could have significant downside. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Canadian data was decent: GDP grew at a 0.4% monthly rate, in line with expectations; Raw material prices, however, contracted by 0.9%; Markit Manufacturing PMI increased to 55.9 from 54.7, beating expectations of 54.8; The Canadian economy is still booming alongside a stellar labor market. Higher oil prices and higher wages will add to inflationary pressures this year, prompting the BoC to tighten in line with expectations. Report Links: Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been mixed: The trade balance underperformed expectations, coming in at 2.6 billion. However it increased from the previous month reading. The KOF indicator also underperformed expectations, coming in at 106.9 However the SVME PMI outperformed expectations, coming in at 65.3 EUR/CHF has depreciated by about 0.75% this week, as risk-on assets have lost ground due to the perception that a correction in the markets might be overdue. Overall, while Swiss inflation is on the rise, it is not yet high enough to cause the SNB to abandon its current dovish tilt. Thus, unless global markets weaken meaningfully, downside to EUR/CHF will likely be limited. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway has been mixed: Retail sales growth surprised to the downside, coming in at -1%. This measure also declined from 2.1% on the previous month. However, Norway's credit indicator outperformed expectations, coming in at 6.3%. USD/NOK has fallen by roughly 0.8% this week, as the fall in the dollar continues to weigh on this cross. Overall, we expect the krone to have upside against the Canadian dollar, as the market is pricing 3 rate hikes in the next 12 months for the BoC, while only pricing 27 basis points for the Norges Bank. While it is true, that the recovery is much more advanced in Canada than in Norway, given the surge in oil prices, the gap in rate expectations should narrow. This will weigh on CAD/NOK. Report Links: Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Swedish Manufacturing PMI surprised to the downside, coming in at 57 compared to the expected 60. Manufacturing PMI in Sweden has been declining since April last year. However, inflation has been in line with the target thanks to higher energy prices and the weakness of the cheapness of the SEK. This year, the Riksbank also seems to be slowly moving away from its dovish stance. This has allowed the SEK to recoup some of its 2017 losses against the euro. We may see a stronger SEK this year as the Riksbank is likely to turn hawkish quicker than the ECB. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 The Xs And The Currency Market - November 24, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights China's new exchange rate regime has significantly weakened the link between the U.S. dollar and the broad RMB trend, at the expense of a stronger (negative) relationship between CNY/USD and the dollar. Our metrics to gauge the impact of broad RMB movements on exports suggest that the recent rise is not yet a threat to China's economy. A further 5% depreciation in the U.S. dollar would cause a meaningful further increase, but not one large enough for our metrics to flash a warning sign. Several factors argue against the probability of an August 2015-style CNY/USD devaluation. Even if the PBOC were to do so, global investors would likely react very differently than they did in 2015, given the underlying strength of the global economy. Stay overweight Chinese investable stocks over the cyclical investment horizon, despite a likely dollar-driven retracement in CNY/USD over the coming months. Feature Chart 1A Sharp Rise In CNY/USD The Chinese Renminbi (RMB) has risen over 4% versus the U.S. dollar since mid-December, and global investors have begun to take notice (Chart 1). The sharp acceleration in the RMB has raised several questions in the minds of market participants: What is the likely economic impact of the rise, and how does this fit into the view that China's ongoing growth slowdown is likely to be benign and controlled? How will policymakers respond to the strength in the exchange rate? Is there a risk of a 2015-style depreciation that would roil global financial markets? In this week's report we offer our perspective on these issues, and provide investors with forecasts for the RMB assuming a 5% appreciation or depreciation of the U.S. dollar versus major currencies over the coming 6-12 months. While it is true that the broad RMB trend has risen non-trivially over the past year, we conclude that is too early to view this rise as a threat to the export sector. This supports our view of a benign, controlled economic slowdown in China, as well as a cyclical overweight stance towards Chinese equities. Putting Recent Exchange Rate Movements In Context In order to answer the questions noted above, it is important to examine recent exchange rate movements in the context of China's ongoing efforts to internationalize the RMB, as they have had a substantial impact on the relationship between the RMB and the U.S. dollar over the past few years. Beijing has been taking steps for years to promote the global use of the RMB, but these efforts came into sharp focus on August 11-12, 2015, when the PBOC devalued the currency versus the U.S. dollar (Chart 2). In addition to the devaluation, the PBOC changed the way that the daily fixing rate would be set, in a fashion that increased the sensitivity of the rate to market forces. The PBOC made these changes at the time that they did for two specific reasons: The IMF was in the process of deciding whether to include the RMB in the SDR basket, after having stated that a more market-based RMB rate was a precondition for inclusion. The policy to link the RMB to the U.S. dollar was causing significant appreciation of the former during a period of enormous dollar strength. Given the decision to alter the fixing rate mechanism, the PBOC decided to devalue the exchange rate by a modest amount in one, bundled policy change. The important point for investors is that the market turmoil that followed the August 2015 changes to the exchange rate overshadowed a much more consequential announcement on December 11, 2015 that precipitated a shift in the link between the RMB and the US dollar (USD) towards multiple currencies.1 At first blush, the "decision" made by the PBOC in December was trivial: they announced that the China Foreign Exchange Trade System (CFETS) would publish an index for the RMB measured against a basket of foreign currencies. But the implication of the announcement was that the PBOC was shifting its focus from managing CNY/USD to managing the value of the RMB versus the currencies of many trading partners. Essentially, December 2015 marked the beginning of a new exchange rate policy in China. The effect of this new policy change can clearly be seen in the relationship between CNY/USD and the trade-weighted RMB versus the U.S. dollar (Chart 3). The chart highlights that the beta of J.P. Morgan's nominal trade-weighted RMB versus the Bloomberg U.S. Dollar Spot Index was strongly positive prior to 2016, whereas the beta of CNY/USD to the Dollar Index was weak. Following the PBOC's policy shift, these relationships traded places: the beta between CNY/USD and the dollar became much more negative, whereas the strength of the U.S. dollar / trade-weighted RMB link weakened considerably. Chart 2The August 2015 Deval Significantly##br## Impacted Global Markets Chart 3A New Exchange Rate Regime Began##br## In December 2015 Bottom Line: China's new exchange rate regime has significantly weakened the link between the U.S. dollar and the broad RMB trend, at the expense of a stronger (negative) relationship between CNY/USD and the broad dollar trend. The Economic Implications Of China's New Exchange Rate Policy Chart 4The Recent Rise In CNY/USD ##br##Has Been Dollar-Driven Given our discussion above, the recent strength of the CNY/USD exchange rate should not be surprising: Chart 4 highlights that its sharp rise is largely the mirror image of recent U.S. dollar weakness. Panel 2 illustrates another way of observing this effect; EUR/USD typically trades inversely to the broad dollar trend, and CNY/EUR has been little changed over the past six months. The key questions for investors are 1) how to assess what impact the broad RMB appreciation over the past year will have on Chinese export growth, and 2) what future dollar movements might imply for the broad RMB trend. We use two metrics to gauge the likely impact of broad exchange rate movements on export growth: a fair value assessment (Chart 5), and the rise of an export-weighted RMB index relative to its high and low points over the past few years, when the exchange rate was clearly negatively and positively contributing to monetary conditions (Chart 6). The charts highlight that the real effective RMB is currently cheap, and that a nominal export-weighted index is only marginally above the median value since 2015. Neither of these measures implies that the rise in the RMB has reached levels that would be restrictive for exports. Chart 7 shows that the annual growth rate of our export-weighted RMB index has been predicted quite well by that of the dollar index and the CNY/USD exchange rate over the past two years. Based on this regression, Chart 8 presents what is likely to occur to our export-weighted RMB index in a 5% appreciation & depreciation scenario. The chart shows that the impact of a 5% appreciation (which we expect) will be muted, whereas a 5% depreciation in the dollar would cause a meaningful further rise in the export-weighted RMB. Still, it would not be enough to push the index to a new high, nor would it cause the real effective RMB shown in Chart 5 to rise into expensive territory. Bottom Line: Our metrics to gauge the impact of broad RMB movements on exports suggest that the recent rise is not yet a threat to the export sector. A further 5% depreciation in the U.S. dollar would cause a meaningful further increase, but not one large enough for our metrics to flash a warning sign. Chart 5The RMB Is Cheap In REER Terms Chart 6Rising, But Not Yet Near Previous Highs Chart 7The Dollar and CNY/USD Explain ##br##The Broad RMB Trend Chart 8Further Dollar Depreciation Would Bite, ##br##But Not Disastrously So August 2015, Redux? Given that the PBOC's devaluation of the RMB in August 2015 roiled global financial markets, it seems natural to ask whether the Chinese central bank could cause another shock by again depreciating the CNY/USD exchange rate. In our view, the answer is no. First, there are several reasons why the PBOC is unlikely to intervene to limit a rise in CNY/USD barring material further strength: Trade frictions with the U.S. remain, and a stronger CNY/USD could reduce the likelihood that the Trump administration will levy across-the-board tariffs on Chinese imports The PBOC recently reduced the influence of the "counter-cyclical factor" that was included in the CNY/USD midpoint formula. Since the factor was introduced to lessen the impact of market forces on the yuan's reference rate, the PBOC would likely have refrained from making any changes to it if they were unduly worried about the upward impact of recent dollar declines on CNY/USD If the PBOC becomes uncomfortable with the extent of the RMB rise in trade or export-weighted terms, it could aim to lower the yuan versus other key trading partners, including the euro area. As noted above, CNY/EUR has recently remained flat during the euro's sharp recent upleg versus the dollar. We noted that the RMB is now cheap in real effective terms (Chart 5), unlike in August 2015 when the deviation from fair value was the highest that it had been since mid-2000. Chart 92015 Vs Today: A Completely Different ##br##Global Economic Backdrop Second, even if the PBOC were to depreciate the CNY/USD exchange rate over the coming months, we doubt that investors would react in the same way as they did to the initial devaluation. As we reviewed in a Weekly Report last October,2 the global economy was suffering from a synchronized slowdown, and the surprise decision caused global investors to speculate heavily that additional devaluations were likely. The current condition of the global economy is clearly quite different than that which prevailed in the summer of 2015. Global PMIs are the most synchronized that they have been since the earliest phase of the economic cycle (Chart 9), which suggests that a significant slowdown is not imminent. Even if the pace of growth becomes narrower or slows modestly, it is difficult to envision the same kind of panicked response absent a separate and highly impactful accompanying shock. Bottom Line: Several factors argue against the probability of an August 2015-style CNY/USD devaluation. Even if the PBOC were to do so, global investors would likely react very differently than they did in 2015, given the underlying strength of the global economy. Investment Strategy Implications Chart 10Export Impact Of The RMB Appreciation##br## Is Non-Trivial, But Manageable Over a 6-12 month time horizon, there are two investment strategy implications of our above discussion. First, our analysis suggests that investors should focus on the broad RMB trend rather than the CNY/USD exchange rate when determining the likely impact of currency fluctuations on China's growth picture. It is true that an export-weighted RMB index has risen by a greater amount over the past year than a typical trade-weighted RMB (or the CFETS RMB index) would suggest (Chart 10), but for now it is too early to conclude that this represents a threat to the export sector. This conclusion is consistent with our view that China's ongoing economic slowdown will be benign, and controlled in nature. Second, given the tight (negative) link between CNY/USD and the U.S. dollar, and our view that USD is more likely to appreciate than depreciate over the coming months, it is true that the US$ relative performance of Chinese equities may be somewhat negatively impacted by a retracement in CNY/USD. But as we noted when presenting our "decision tree" for Chinese stocks at the beginning of the year,3 the cyclical condition of China's business cycle is the dominant factor that investors should consider when judging the appropriate allocation to Chinese equities. As such, our focus on China's exchange rate remains on how it impacts the growth outlook, and our judgement on this question continues to support a favorable stance towards the equity market. Bottom Line: Stay overweight Chinese investable stocks over the cyclical investment horizon, despite a likely dollar-driven retracement in CNY/USD over the coming months. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 http://www.pbc.gov.cn/english/130721/2988680/index.html 2 Please see China Investment Strategy Weekly Report, "China's Economy - 2015 Vs Today (Part I): Trade", dated October 26, 2017, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Weekly Report, "The Decision Tree For Chinese Stocks", dated January 4, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights Even though our baseline scenario calls for four rate hikes out of the Fed this year - more than markets have priced in - gold will be supported by increasing inflation and inflation expectations, heightened geopolitical risks, and greater volatility in equity markets. Further out, we expect gold will provide a good hedge against a likely equity downturn, as the bull market turns into a bear market in 2H19. For now, keep gold as a strategic portfolio hedge. Energy: Overweight. After popping above $70 and $66/bbl last week, Brent and WTI prices retreated ~ $2.00/bbl on the back of a stronger USD and increased rig counts in the U.S. shales, particularly in the prolific Permian Basin, where 18 rigs were added. We continue to expect Brent and WTI prices to average $67 and $63/bbl this year. Base Metals: Neutral. Spot copper continues to trade on either side of $3.20/lb on the COMEX. We remain neutral, given our view upside risk - chiefly supply-side disruptions at the mine and refined levels - will be balanced on the downside by a stronger USD and a slowdown in China. Precious Metals: Neutral. Gold will draw support from rising inflation and inflation expectations this year and next (see below). Ags/Softs: Underweight. NAFTA negotiations ended this week in Montreal with the U.S. rejecting proposals from Canada to advance the talks. However, the U.S. side stated it would seek "major breakthroughs" at the next round of negotiations in Mexico City beginning February 26, according to agriculture.com. Feature Gold Price Risks Skewed To The Upside Price risk in gold will remain skewed to the upside this year, even as our base case scenario calls for limited gains from here. Higher inflation and inflation expectations, which normally would be bullish for gold, will be countered by Fed policy-rate hikes, which will boost the USD and lift real rates in our base case (Chart of the Week). Inflation's Revival Would Support Gold ... Despite above-trend global growth last year, subdued inflation limited the Fed's willingness to proceed with interest rate normalization in earnest. However, we do not put this down to structural forces, and instead expect core inflation to be near its bottom.1 In fact, inflation's soft readings are typical of the expected 18-month lag between U.S. economic growth and a pick-up in inflation, and as our Global Investment Strategists point out, several key indicators including the ISM manufacturing index, the New York Fed's Inflation Gauge, as well as BCA's proprietary pipeline inflation index are already moving in this direction (Chart 2).2 Chart of the WeekInflation And U.S. Financial Variables Matter Chart 2Signs Of Life In U.S. Inflation Inflation tends to pick up once the unemployment rate falls below the 5% mark. With the latest unemployment reading coming in at 4.1%, the U.S. economy has reached the steep end of the Phillips Curve - a workhorse model used by the Fed, which depicts the trade-off between unemployment and inflation. Indeed, BCA's Global Investment Strategists expect the U.S. unemployment rate to continue falling to a 49-year low of 3.5% by year-end. These further declines in the unemployment rate will push up wages, pressuring service inflation (Chart 3). At the same time, we expect the lagged impact of the weak USD will begin to show up in goods price inflation, along with higher energy prices. While some components of the Fed's preferred inflation gauge may face a slowdown in price pressure - most notably rent - this will likely be mitigated by accelerating prices in other components, such as health care, which we expect will return to its historic trend. In fact, U.S. inflation expectations - supported by higher energy prices and a strong December core CPI reading - have already started to increase (Chart 4). As our U.S. Bond Strategists point out, by the time core inflation returns to the Fed's target, the 10-year TIPS breakeven inflation rate will be between 2.4% and 2.5%.3 Chart 3At The Steep End Of The Philips Curve Chart 4A Breakout In Inflation Expectations Thus the 2018 inflation outlook is showing signs that it is in the process of bottoming, and will soon begin its ascent. We expect core PCE inflation, the Fed's preferred gauge, to reach the central bank's 2% target by year-end. This pick-up in inflation and inflation expectations is positive for gold, which we've shown to be an attractive hedge against rising prices. However, inflation's comeback will likely embolden the Fed to proceed more aggressively with its hiking cycle. ... But A Hawkish Fed Counters Inflation ... While our modelling showcases an inverse relationship between real rates and gold prices, what is crucial to our outlook is our expectation of how the Fed will proceed with its interest rate normalization process this year. Given that gold's correlation with inflation is strengthened during periods of low real rates, the ideal condition for gold would be for the Fed to stay behind the inflation curve. But we are not expecting that just yet.4 Rather than waiting to see the "whites of inflation's eyes," our expectation is the Fed will tighten ahead of inflation. This has in fact already materialized with three hikes in 2017 amid muted inflation. Upward surprises in U.S. growth, coupled with an upward trend in inflation will keep the Fed on its normalization path with greater confidence. We expect four rate hikes in 2018 - above both market expectations and what is implied by the "dot plot". Net, the pre-emptive Fed rate hikes we expect will lead to higher real rates, and will limit gold's upside this year. ... As Does A Stronger Greenback An increase in U.S. real rates vis-à-vis other economies, as well as a shift in the composition of global growth to favor the U.S., will support the USD. In addition to higher real rates, this would also limit gold's upside in 2018. Stronger growth ex-U.S. last year weakened the USD. This year, we expect the U.S. economy to outperform. Financial conditions have eased in the U.S. relative to the rest of the world, while fiscal policy is expected to be comparatively more favorable in the U.S. The U.S. surprise index has reflected this shift in comparative growth, outperforming most regions (Chart 5).5 While the Euro has been exceptionally resilient, the fallout from a stronger currency will eventually begin to show up in slower growth. The EUR/USD cross has diverged from the spread in expected policy rates, leaving the euro looking expensive (Chart 6). Since the beginning of the year, spreads have widened in favor of the dollar, while the USD has weakened. Although we do not expect the ECB to hike until mid-2019, our expectation of four Fed rate hikes this year will support the greenback. This will push spreads back in line. Such decoupling is not the norm, and we expect a 5% appreciation in the dollar in broad trade weighted terms.6 Chart 5Economic Surprises Favor The U.S. Chart 6EUR Looks Expensive Still, The Fed Could Surprise, And Tilt Dovish Chart 7A Policy Change Would##BR##Tolerate Higher Inflation A risk to our base case outlook is a change in the Fed's monetary policy framework. Here we note an increasing number of statements advocating the exploration of an alternative policy framework have been emerging from the Fed. This line of attack observes the Fed's current 2% inflation target is unsatisfactory, as it is too close to the zero-lower bound on interest rates, thus constraining the Fed's ability to exercise expansionary monetary policy when rates are low.7 Alternative policy proposals include price-level targeting, as well as an increase in the inflation target. Additionally, former Fed Chair Bernanke recently proposed a temporary price level target be implemented during low-rate periods.8 The net effect of these alternatives would be a higher inflation rate - above the current 2% target (Chart 7). If the Fed were to adopt a new monetary policy framework, it will likely occur before the next recession - in order to allow it to better respond to economic weakness. While we do not expect a regime change this year, these discussions and an eventual shift, may make the Fed more dovish this year, and more likely to tolerate higher inflation in the future. This would be an upside risk to gold, as it would assume its role as a store-of-value against higher inflation. The net effect of such a policy change - were it to occur - would be higher inflation expectations, lower real rates, and a weaker USD, all of which would bid up the gold market. Bottom Line: The revival of U.S. inflation and inflation expectations will bolster gold. However, our expectation that the Fed will continue hiking ahead of a realized uptick in inflation, and more aggressively than is currently priced in the market, will increase real rates and limit gold's upside potential. A stronger USD on the back of higher real rates, as well as a shift in global growth in favor of the U.S., will work against gold this year. Geopolitical Risks: Understated In 2018 We expect geopolitical risks to support gold prices this year. Gold's safe-haven attributes will be highlighted by a combination of events spread across the calendar year, which we believe will put a floor under the metal's price (Chart 8).9 Political and economic policy uncertainty will remain elevated this year (Chart 9). Our Geopolitical Strategists see this year's gold-relevant risks stemming from two main factors: (1) U.S. political risks, and (2) Exogenous tail risks. The former is likely to be a more significant source of upside pressure. Chart 8Gold Outperforms During##BR##Geopolitical Crises Chart 9Elevated Policy Uncertainty##BR##Supports Gold U.S. Foreign Strategy Risks Will Keep Gold Bid U.S. political risks are rooted in President Trump's strategic decisions, and boil down to two mutually exclusive schemes ahead of the midterm elections: Domestic Strategy or Foreign Strategy (Table 1). Our Geopolitical strategists note: "... policymakers often play "two-level games," with the domestic arena influencing what is possible in the international one. As Donald Trump loses political capital on the domestic front, his options for affecting policy will become constrained. However, the U.S. constitution places almost no constraints on the president when it comes to foreign policy."10 Trump's propensity to take on a more aggressive stance in foreign policy - which would be boosted by an unfavorable outcome in the immigration bill - will set the stage for a volatile year, supporting gold via its ability to hedge against geopolitical risks (Chart 10). Table 1Trump's Two-Level Game Chart 10Trump Will Look To Revive His Political Capital In addition to the U.S. political risks, many low-probability high-impact risks will keep volatility elevated this year and could support gold as a strategic portfolio hedge in 2018. Most notable are the following: A meaningful slowdown in China would have a negative impact on the global economy, as well as increase the risk of a monetary policy mistake in the U.S. The Fed's monetary policy decision is important for EM growth, while EM growth contributes to U.S. inflation, this feedback system makes the expected slowdown in Chinese growth relevant to the U.S. monetary stance. If China slows more than expected, this would reduce the global demand for commodities and goods, diminishing U.S. inflation expectations, potentially forcing the Fed to reassess its rate hike pace. If no adjustments are made, the Fed risks overshooting the equilibrium interest rate, increasing the risk of an equity correction. A downward rate hike adjustment, would keep the USD and real rates at low levels. A global oil-supply disruption caused by a collapse of the Venezuelan economy would lead to a short-lived spike in oil prices (Chart 11). In low-spare-capacity environments - as we are in today - oil prices become more responsive to supply shocks. Based on our simulations, a 600k b/d drop in Venezuelan oil supply in 2018 could spike oil prices by ~$10/bbl, leading to higher cost-push inflation. Our modelling shows U.S. CPI is highly responsive to oil price variation. This spike in headline inflation would push gold prices higher. Chart 11Cost-Push Inflation Risk From Venezuela Collapse In addition to U.S.-Iran tensions, we see other potential catalysts to instability in the Middle East - mainly regarding a severe deterioration of the U.S.-Turkish relationship, and Iraqi-Kurdish clashes ahead of Iraqi elections. Lastly, Europe: Italian elections and Euro-skepticism are a longer-term risk; however, news around the Italian elections in March has the potential to fuel talk of a potential breakup, which could lift gold.11 Bottom Line: Increased tensions due to Trump's controversial foreign strategy (China and Iran), as well as exogenous tail risks throughout the year will keep risks elevated in 2018, supporting gold prices. In fact our geopolitical strategists believe risks are understated this year, increasing the utility of gold's ability to hedge against political turmoil. Gold Outperforms In Equity Bear Markets In addition to its ability to hedge against rising inflation and increased geopolitical risks, gold outperforms during equity downturns and amid market volatility.12 Specifically, during periods of negative equity returns, gold outperformed the S&P500 79% of the time, with an average excess return of 3.7%. Furthermore, gold outperforms equities 60% of the time in periods of rising VIX with an average excess monthly return of 1.6% in these periods, and only 30% of the time in decreasing VIX periods with an average monthly excess return of -1.8% (Chart 12).13 We expect the equity bull market to remain intact throughout 2018. An equity downturn is not expected before 2H19. Nevertheless, we expect volatility to increase this year as investors fret about the sustainability of the bull market, and amid heightened geopolitical tensions. Moreover, domestic U.S. developments - e.g., the evolution of Special Counsel Robert Mueller's investigation; a larger-than-expected Democrat win in the midterm elections or a Fed policy mistake - could affect investor sentiment and trigger a rise in volatility and a temporary sell-off in S&P 500. In our view, consumer confidence is a key contributor to the current equity bull market and currently stands at very elevated levels (Chart 13). Thus, any meaningful disappointment could derail this high-confidence environment. Chart 12Gold Outperforms Amid##BR##Volatility & Equity Downturns Chart 13High Confidence##BR##Environment At Risk Therefore, we believe the larger-than-expected tail risks and the monetary and political risks in the U.S. are not fully reflected in the gold market (Chart 14). The above risks assessment would suggest a fatter right tail in out-of-the-money gold options. Chart 14Rising Volatility Will Support Gold Chart 15Understated Geopolitical Risks This Year Bottom Line: While geopolitical risks were overstated in 2017, they are understated this year (Chart 15). Thus we do not expect a repeat of last year's low-VIX high-confidence environment. Rather gold will gain support from increased equity volatility this year. Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com Hugo Bélanger, Research Analyst HugoB@bcaresearch.com 1 Please see BCA Research The Bank Credit Analyst Special Report titled "The Impact of Robots on Inflation," dated January 25, 2018, available at bca.bcaresearch.com. 2 Please see BCA Research Global Investment Strategy Weekly Report titled "Three Tantalizing Trades - Four Months On," dated January 19, 2018, available at gis.bcaresearch.com. 3 Please see BCA Research U.S. Bond Strategy Weekly Report titled "It's Still All About Inflation," dated January 16, 2018, available at usbs.bcaresearch.com. 4 Please see BCA Research Commodity & Energy Strategy Weekly Report titled "Go Long Gold As A Strategic Portfolio Hedge," dated May 4, 2017, available at ces.bcaresearch.com. 5 Please see BCA Research Global Investment Strategy Weekly Report titled "Four Key Questions On The 2018 Global Growth Outlook," dated January 5, 2018, available at gis.bcaresearch.com. 6 Please see BCA Research Global Investment Strategy Weekly Report titled "The Indefatigable Euro," dated January 26, 2018, available at gis.bcaresearch.com. 7 Please see "Fed Officials See Benefits In Letting Inflation Run Above Target," dated January 19, 2018, available at Bloomberg.com. 8 Please see https://www.brookings.edu/blog/ben-bernanke/2017/10/12/temporary-price-level-targeting-an-alternative-framework-for-monetary-policy/ 9 Please see BCA Research Commodity & Energy Strategy Weekly Report titled "Balance Of Risks Favors Holding Gold," dated October 12, 2017, available at ces.bcaresearch.com. 10 Please see BCA Research Geopolitical Strategy Weekly Report titled "Watching Five Risks," dated January 24, 2018, available at gps.bcaresearch.com. 11 For a comprehensive analysis of this issue, please see BCA Research Geopolitical Strategy Special Report titled "Five Black Swans In 2018," dated December 6, 2017, available at gps.bcaresearch.com. 12 Please see BCA Research Commodity & Energy Strategy Weekly Report titled "Go Long Gold As A Strategic Portfolio Hedge," dated May 4, 2017, available at ces.bcaresearch.com. 13 Excess returns = (Gold - S&P 500) monthly returns. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017

Highlights The U.S.'s twin deficits do not explain the drop in the USD; Global growth is the biggest factor for the USD, and growth depends on China's economic reforms; The U.S. is turning more hawkish on China trade despite Beijing's reform-induced vulnerability; U.S. and Chinese political dynamics suggest upside risks in the former and downside in the latter; Go long DXY. Feature American policymakers scrambled to walk back Treasury Secretary Steven Mnuchin's "weak dollar" comments last week. Investors were left to wonder why Mnuchin broke with the long-held official position of favoring a strong dollar. Was it a "shot across the bow" of China, warning Beijing that the U.S. would engage in currency manipulation if it was not given concessions on trade? Or was it an admission that the U.S. would run large "twin deficits" - a budget deficit and a current account deficit - going forward? We don't have a good explanation for what Mnuchin said in Davos.1 But we can say with some conviction that the "twin deficit" explanation, which has been brought up in almost every client conversation so far this year, is wrong. Chart 1Twin Deficits: Why The Panic? Chart 2Because The Narrative Is Scary First, who says that the U.S. is about to widen its twin deficit (Chart 1)? The concern arises periodically in the marketplace but is often grossly off the mark in predicting the path of deficits or the dollar (Chart 2). We expect the budget deficit to hold steady in 2018, if not contract. Why? Because the fiscal deficit almost always contracts in the eight quarters before a recession, barring, in some cases, one or two quarters just before the recession hits (Chart 3). Unless investors have a high-conviction view that a recession is afoot in the next two quarters, they should ignore the dire predictions about the U.S. budget deficit. Chart 3The Deficit Is Not A Problem... Yet Chart 4Bond Market Not Sniffing Out Any Twin Deficit Crisis If the risk to the U.S. economy is to the upside, as we believe due to the tax cuts and unleashing of animal spirits, then deficits will come down regardless of additional tax or spending policy.2 In the long term, yes, the budget deficit will almost certainly expand due to entitlement spending, the impact of automatic stabilizers during a recession, and the loss of revenue from tax cuts. But long-term deficit concerns are the purview of the bond market, not currency traders. So what is the bond market telling us? Chart 4 shows that the yield curve tends to steepen as the twin deficit widens; both tend to occur during and after recessions. Today, however, the curve continues to flatten. Another fixed-income market indicator that tends to track budget deficits is the 30-year swap spread, which falls during recessions as budget deficits expand. But today the swap spread is not falling, it is increasing and doing so at the fastest pace since the 2008 recession (Chart 5). This may be a sign of resurgent animal spirits as banks throw caution - and concerns over Obama-era overregulation - to the wind. Credit demand is rising in the economy, which should increase both the velocity of money and growth. Concerns over the widening fiscal deficit are not being reflected in this indicator. Finally, our currency strategist, Mathieu Savary, has pointed out that a widening twin deficit only impacts developed economies' currencies about 50% of the time over 12 month periods. In other words, expansion of the twin deficit predicts currency moves about as well as flipping a coin. What really matters is how central banks respond to the causes and economic effects of the twin deficits. Protectionism, on the other hand, ought to be bullish for the dollar.3 As such, a potential trade war between China and the U.S. should not be the reason for the dollar's deepening doldrums. And while we are generally open to alarmism on trade protectionism - due to the fact that President Trump has few constitutional or political constraints holding him back on this issue - there is still not enough evidence to say whether the Trump administration will impose across-the-board tariffs on China. (See next section.) Could dollar weakness, conversely, be the result of a Plaza Accord 2.0 orchestrated between Chinese and American policymakers to depreciate the greenback in order to avert the need for protectionist policies? We doubt it. First, the U.S. and China economic dialogue has faltered. Second, the dollar would not have declined following the Plaza Accord had the Fed not aggressively cut rates from 1984 to 1985 by 423 basis points (Chart 6). And the Fed is obviously not cutting rates today, it is hiking them. Chart 5No Sign Of Deficit Here Chart 6The Fed Is More Important Than Politics... So, what matters for the U.S. dollar? Higher domestic inflation would matter as it would incentivize the Fed to tighten more than the market expects. Even here, however, recent history warrants caution on this view. Between 2004 and 2006, the Fed tightened 440 basis points and yet the dollar declined 11% from the start of the tightening cycle to its end (Chart 7). This is because the rest of the world's growth outpaced U.S. growth, particularly that of emerging markets, which grew at an annual 19%. We therefore come full circle to the single biggest issue on our forecasting horizon: Chinese policy. China is the most important variable for the U.S. dollar at the moment as it can single-handedly tip the global growth balance back towards the U.S., given its expected contribution to global growth (Chart 8). Chart 7...But Not More Important Than Global Growth Chart 8China Really Matters For Global Growth Our view is that Chinese policymakers are acting as an accelerant to BCA's House View that the Chinese economy will experience a benign slowdown. Risks are skewed towards the downside. We recently dedicated our monthly Crow's Nest Webcast solely to this issue and we highly encourage our clients to listen to it on replay.4 In today's weekly, we briefly assess where our Chinese view stands and then turn to U.S. politics. News Flash: Chimerica Has Been Dead Since 2012 Two critical aspects of our China view are coming together. The first is U.S. policy, which is becoming more aggressive after a year in which Trump showed restraint for the sake of North Korean negotiations.5 The second is China's renewed focus on domestic economic reforms.6 The "symbiotic" relationship between the U.S. and China is in decay, as we have argued since 2012.7 As China's economy grows, so grows its capacity for challenging the United States in the strategic sphere (Chart 9). Meanwhile the two economies have diverged markedly since U.S. households began to deleverage in 2008 (Chart 10). Chart 9China's Capabilities Are Growing Chart 10China No Longer Addicted To U.S. Demand The mainstream media is about to become more attuned to this reality now that the Trump administration has published a series of high-level reports declaring that U.S. strategy toward China is changing. Here are a few choice quotations: "China is a strategic competitor using predatory economics to intimidate its neighbors while militarizing features in the South China Sea." (Department of Defense, National Defense Strategy, 2018) "Long-term strategic competitions with China and Russia are the principal priorities for the Department." (Department of Defense, National Defense Strategy, 2018) "[High-level bilateral dialogues] largely have been unsuccessful - not because of failures by U.S. policymakers, but because Chinese policymakers were not interested in moving toward a true market economy." (U.S. Trade Representative, 2017 Report to Congress On China's WTO Compliance, 2018) "The United States also will take all other steps necessary to rein in harmful state-led, mercantilist policies and practices pursued by China, even when they do not fall squarely within WTO disciplines." (U.S. Trade Representative, 2017 Report to Congress On China's WTO Compliance, 2018) "The United States ... is seeking fundamental changes to China's trade regime, including the overarching industrial policies that have continued to dominate China's state-led economy." (U.S. Trade Representative, 2017 Report to Congress On China's WTO Compliance, 2018) "China and Russia want to shape a world antithetical to U.S. values and interests. China seeks to displace the United States in the Indo-Pacific region, expand the reaches of its state-driven economic model, and reorder the region in its favor." (President Trump, National Security Strategy of the United States of America, 2017) We expect to find echoes of this tough rhetoric in Trump's State of the Union Address on January 30, which will air as we go to press. Already commentators have declared that the U.S. is entering a "post-engagement" phase in the U.S.-China relationship.8 The U.S. and China will continue to engage. What is important is the Trump administration's shift toward more aggressive economic statecraft. Trump's view, made amply clear on the campaign trail, and now officially U.S. policy, holds that China is a mercantilist as well as a revisionist power and that it has initiated a trade war against the U.S. Thus the real policy change lies not in naming China a "strategic competitor" antithetical to U.S. values, but in declaring that normal "WTO consistent" remedies are no longer sufficient and the U.S. will have to resort to "all other steps necessary." The question is whether the U.S., in adopting unilateral measures, will pursue trade remedies on an item-by-item basis, as it has done so far, or break out of the mold and levy broader tariffs to try to achieve "fundamental changes" as quoted above. Trump's recent tariffs on solar panels and washing machines adhered closely to U.S. institutional procedures and penalized U.S. ally South Korea as well as China: if this is the trajectory that the U.S. intends to take, then markets can breathe a sigh of relief.9 The basic trade data show that the U.S. has continued to expand imports from China despite past incidents of presidents slapping on tariffs (Chart 11). Chart 11China And U.S.: Ships Passing In The Night However, the U.S. is likely to draw a harder line than that. The same data also show that the U.S. is not gaining much access to the Chinese market over time, while China has greatly diminished its exposure both to exports and to U.S. trade as a whole. Furthermore, the Trump administration is accusing China of trying to gain superior technology from the U.S. in a way that jeopardizes its security and sovereignty in the pursuit of a better strategic position. This is said to include coercion and corruption of U.S. firms in China, favoring the manufacturing sector by squeezing out competition, preferring domestic-sourced goods over foreign goods, and jeopardizing U.S. companies' intellectual property and network security. The key grievances are forced technology transfer, the "Made in China 2025" industrial strategy, "indigenous innovation" rules, and the new Cyber-Security Law.10 A test case for the U.S.'s harder line will be the ongoing investigation into China's intellectual property theft, which is due by August but is expected to elicit action by Trump sooner. Trump has a range of actions he can take either within or without the WTO. Going outside the WTO would give him greater flexibility, for instance, to impose a "fine," as he called it, for the cumulative "big damages" of China's intellectual property theft - but it would also enable China to claim that the U.S. itself is violating WTO trade rules.11 How will China respond to this turn in U.S. policy? It will continue to focus on rebooting its economic reforms. Reform is both necessary for its own interests, as we have outlined in the past, and expedient in that it enables China to try to deflect and delay U.S. pressure.12 This is not to say that China will not retaliate to particular U.S. moves, but simply that it will prefer to minimize conflict unless and until the Trump administration demonstrates via broad and sweeping trade measures that Beijing has no choice but to engage in open trade war. China's recent declarations that it will accelerate economic reforms aimed at trade and investment openness - particularly in financial services but also more generally - are geared toward allaying Washington. Xi Jinping's right-hand economist, Liu He, who is a key figure, made this clear at the World Economic Forum in Davos, where he said that China's reform and opening up this year would "exceed international expectations." Politburo Standing Committee member Wang Yang made a similar point late last year, saying that the "Made in China 2025" program would not discriminate against foreign or private firms.13 Simultaneously, leading technocrats are calling attention to China's vulnerability as it attempts delicate financial reforms. Guo Shuqing of the China Banking Regulatory Commission has warned of "black swan" or "gray rhino" events as he continues with his financial regulatory crackdown, and he has been echoed by the vice-secretary general of the National Development and Reform Commission.14 These statements are prudent - as it is always risky for highly leveraged countries to tinker with financial tightening - and useful because Beijing wants to warn the U.S. against pushing too hard since it is both "making progress" and vulnerable to instability. We certainly expect the reforms to have a significant, adverse impact on China's economic growth this year. In the latest developments, the policy crackdown is spreading to local governments, where fiscal tightening could ensue (Chart 12). Local governments lack stable sources of revenue, have large hidden debts, face an intensifying debt repayment schedule over the next three years, and have recently begun to cancel infrastructure projects under central government scrutiny (in Inner Mongolia, Gansu, and other provinces, and reportedly even in Xi's favored province of Zhejiang). Furthermore, the reforms have involved a crackdown on shadow lending that has sent non-bank credit into a steep decline (Chart 13). While some market estimates suggest that bank loans could grow by 13%-15% in 2018, such estimates cut against the policy grain. Assuming that non-bank credit does not grow any faster in 2018 than it did in 2017 (9.7%), China can afford to let new bank loans grow at 9.7% and still keep its total social financing (TSF) at its five-year annual average growth rate of 14.5%. Policymakers will not be able to soften their line easily, as several key players are newly appointed and must establish their credibility from the outset. Chart 12Local Government Finances Under Scrutiny Chart 13Shadow Bank Crackdown To Weigh On Credit Growth Our view is that Trump will harden the line despite China's promises both of deeper internal reforms and greater opening up. But the timing is impossible to predict. The real fireworks may be reserved until closer to the U.S. midterm election, as campaigning heats up in the fall. That would be the time for Trump to try to rally his voters by means of a clash of economic nationalisms with China. Beyond the top U.S. grievances cited above, we would highlight the U.S. approach toward China's state-owned enterprises (SOEs). Preferential policies for SOEs are a structural issue that the U.S. is now criticizing. At the party congress in October, President Xi Jinping pledged not only to reform the SOEs but also to make them bigger and stronger. Hence there is a potential collision course. The precise implementation of China's reforms could determine whether the U.S. pursues the issue further. China's State-Owned Assets Supervision and Administration Commission has so far reaffirmed Xi's comments at the party congress but, in keeping with the subtlety of Xi's policies, has also suggested there may be room to intensify reforms. The combination of Trump's economic policies, and China's intensifying reforms, will result in the U.S. economy outperforming expectations relative to China while U.S. corporations will outperform their Chinese counterparts (Chart 14). China will experience higher volatility, both in general and in relation to the U.S., and Chinese companies that suffer from reforms will underperform U.S. companies that benefit most from tax cuts (Chart 15). This is ironic given the popular narrative that the U.S. is suffering from chaotic democratic politics while China's centralized authoritarian model reigns triumphant. Of course, we do think Xi has key capabilities to drive reforms further in his second term than in his first, so these U.S.-China divergences will continue for the next 6-to-12 months at least. China's slowdown and increase in equity volatility should create a policy response: more fiscal spending and credit expansion. The comparison of relative U.S. and Chinese credit impulses suggests that China extends more credit as relative volatility rises (Chart 16). Our view, however, is that China's credit impulse will continue disappointing this year as Beijing prioritizes reform over growth. The credit numbers in January are the next data set to watch, in addition to the aforementioned local government spending. Investors should brace for more uncertainty as the Lunar New Year approaches (Feb. 16). Chart 14U.S. Earnings Surprise Relative To China Chart 15Xi Adds Volatility Relative To Trump Bump Chart 16China's Credit Impulse Disappoints Bottom Line: The Trump administration has issued an ultimatum of sorts on trade. Yet China claims to be redoubling its efforts at reforming and opening up its economy - party to deflect the pressure. We are almost certain that Trump will take further punitive actions, but it is too soon to say when or if he will engage in sweeping measures that threaten to destabilize China and thus initiate a trade war. The political context heading into the U.S. midterm vote will be crucial. Is America Having A Macron Moment? It is unfortunate when one's forecast is challenged only weeks after it is conceived. But that appears to be happening to our view, articulated in late December, that investors should expect no significant legislation to come out of Congress following the passage of the tax cuts.15 Bad news for our forecast is perhaps good news for U.S. policy initiatives and the overall quality of U.S. governance. President Trump has softened his stance on immigration, stating that he would be willing to grant citizenship to roughly 1.8 million "Dreamers" - young adults who came to the U.S. as illegal immigrants.16 Clearing the immigration hurdle would mean that Congress can focus on passing a budget for FY2018 that would see both defense and discretionary spending levels significantly raised. It would also relegate the never-ending saga of the debt ceiling to the dustbin, at least for the duration of this political cycle. Trump also followed up his immigration proposal by sketching a $1.7 trillion infrastructure investment plan (albeit a vague one). Chart 17Bipartisanship = Steeper Bull Market? Could we be approaching a "Macron moment" in U.S. politics? A moment when the "silent majority" rises up and sends a message to politicians that it has had enough of polarizing extremes? Previous such moments have included President Reagan's collaboration with congressional Democrats and President Clinton's with Republicans, which underpinned that glorious stock market run between August 12, 1982 and March 24, 2000 (Chart 17). Both presidents passed significant economic and social reforms during that time. Chart 18Peak Partisanship? Chart 19Independents On The Rise Yes, polarization remains at extreme levels (Chart 18), but that could also mean that it is reaching its natural limits. Rather than dwell on the high levels of polarization, which are baked into the "expectations cake," we would point out that the percentage of Americans who identify as independents is now fast approaching the combined total who identify as either Republican or Democrat (Chart 19). Ominously for Republicans - who hold both the House and the Senate - midterm electoral sweeps have almost always occurred along with the share of independents crossing the 40% mark (Table 1). Table 1Sweep Elections Coincide With High Independent Affiliation Meanwhile, President Trump's conciliatory tone on immigration was met with howls of protest from conservative activists. This is despite the fact that his proposal essentially exchanges leniency for Dreamers for considerably tougher immigration laws in general, which would align the U.S. with its developed market peers.17 Conservative activists are, however, massively out of step with the rest of America. Polls show that immigration is not high on the list of priorities for most Americans, and that most Americans continue to believe both that immigration is a positive and that immigration intake should remain at current levels (Chart 20). Chart 20Americans Are Neither Anti-Immigrant Nor All That Concerned About Immigration Our gut call that President Trump was itching to move to the political middle appears to be correct.18 Whether this becomes investment relevant will ultimately depend on whether the Democrats reciprocate. If Democrats go by data, they will. The government shutdown imbroglio has cost them a double-digit lead in the generic congressional ballot (Chart 21). As a political strategy, the shutdown was a miserable failure. Furthermore, the 2016 election stands as clear evidence that "outrage" does not work. Clinton picked up almost a million more voters in California than President Obama yet failed to beat his performance where it mattered: the Midwest. If Democrats continue to run on a "resistance" platform in order to satisfy their activist base, they will fail to win the House. Chart 21Government Shutdown An 'Own Goal' For Dems Ironically, the best strategy for Democrats ahead of the midterm election is to cooperate with Trump. The swelling ranks of independent voters will reward them if they do so. That same strategy, however, will paradoxically boost Trump's chances in 2020. Bottom Line: The market is, of course, ideologically nihilist. But a move to the middle - which benefits everyone involved except House Republicans - would be positive for stocks and the economy. Key bellwethers going forward are how Democrats react to Trump's immigration proposal and whether Trump moves to the middle on trade deals, starting with NAFTA, whose sixth round of negotiations just ended inconclusively (although not negatively) in Montreal. Investment Implications From the perspective of global asset allocation, the most important issue today is Chinese economic and regulatory policy. Yes, U.S. inflation is important, but whether it moves the dollar - and therefore commodities and EM assets - will depend on the pace of the current Chinese slowdown. China is therefore the most "diagnostic variable" in 2018. If our House View that inflation is coming back in the U.S. is right and our Geopolitical Strategy view that risks to growth in China are to the downside is also right, then investors should go long the U.S. dollar and underweight EM and EM-leveraged assets. If, on the other hand, we are wrong, then investors should load up with EM risk assets to the hilt right now. It is that simple. For what it is worth, we are putting our moderate-conviction view to the test and opening a long DXY trade. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com 1 But on a completely unrelated note we would like to remind our clients that, over the past 24 months, Mr. Mnuchin was the executive producer of How to Be Single, Midnight Special, Batman v. Superman: Dawn of Justice, Keanu, The Conjuring 2, Central Intelligence, The Legend of Tarzan, Lights Out, Suicide Squad, Sully, Storks, The Accountant, Rules Don't Apply, The Lego Batman Movie, Fist Fight, CHiPs, Going in Style, Unforgettable, King Arthur: Legend of the Sword, Wonder Woman, The House, Annabelle: Creation, The Lego Ninjago Movie, and The Disaster Artist. 2 Please see BCA Geopolitical Strategy Weekly Report, "Upside Risks In U.S., Downside Risks In China," dated January 17, 2018, available at gps.bcaresearch.com. 3 Please see BCA Global Investment Strategy Special Report, "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017," dated January 20, 2017, and Weekly Reports, "Trump and Trade," December 9, 2016, and "The Elusive Gains From Globalization," dated November 25, 2016, available at gis.bcaresearch.com. 4 Please see BCA Research Webcasts, Geopolitical Strategy Crow's Nest, "China: How Is Our View Working Out?" dated January 25, 2018. 5 Please see BCA Geopolitical Strategy Weekly Report, "BCA Geopolitical Strategy 2017 Report Card," dated December 20, 2017, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, and "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Special Report, "Power And Politics In East Asia: Cold War 2.0?" dated September 25, 2012, "Sino-American Conflict: More Likely Than You Think," dated October 4, 2013, and "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com. 8 Please see Daniel H. Rosen, "A Post-Engagement US-China Relationship," Rhodium Group, January 19, 2018, available at rhg.com. 9 In fact, in the case of washing machines, the U.S.-based GE Appliances stands to gain from the tariff and has been owned by China's Haier Electronics Group since 2016. 10 Several clients have asked us about China's Cyber-Security Law, which has been in the process of implementation since July 2017 and will go fully into effect by the end of 2018. The law is meant to give the Chinese government the option of exercising control over all networks in the country. State security agencies are deeply involved in its enforcement and oversight. Foreign business interests fear that the law's new obligations will be onerous and potentially damaging - including potential violations of corporate security over intellectual property, source code, supply chain details, and data storage and transmission. 11 Please see Stephen E. Becker, Nancy Fischer, and Sahar Hafeez, "Update on US Investigation of China's IP Practices," Lexology, January 8, 2018, available at www.lexology.com. 12 Please see BCA Geopolitical Strategy Special Report, "How To Read Xi Jinping's Party Congress Speech," dated October 18, 2017, available at gps.bcaresearch.com. 13 Wang has served as the top interlocutor with the U.S. in the U.S.-China Comprehensive Economic Dialogue. 14 Please see "China eyes black swans, gray rhinos as 2018 growth seen slowing to 6.5-6.8 percent: media," Reuters, January 28, 2018, available at www.reuters.com. "Gray rhinos," coined by author Michele Wucker, refer to high-probability, high-impact risks, whereas the proverbial "black swan" is a low-probability, high-impact risk. These terms have both been making the rounds more frequently in Chinese policymaking circles since last year. 15 Please see BCA Geopolitical Strategy Special Report, "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 16 What is fascinating about Trump's statement is that he cited the 1.8 million figure. There are actually only about 800,000 people who officially participated in President Obama's Deferred Action for Childhood Arrivals program. But estimates suggest that another 1,000,000 young adults are in the U.S. illegally, yet did not register. Trump has come under criticism from conservative, anti-immigration groups for essentially moving the goalposts beyond what even the Democrats had wanted. 17 Canada, for example, has a purely merit-based immigration system that is considerably tough on family reunification. (Reunification has even been suspended because of a large backlog.) In Europe, family reunification laws are extremely strict. Even spouses are not automatically allowed residency status in several major European countries unless they fulfill various conditions. 18 Please see footnote 2 above.

Highlights A potential rise in U.S. inflation and China's growth slowdown represent formidable headwinds to EM risk assets. A manifestation of these tectonic macro shifts will be a U.S. dollar rally and weakening commodities prices. These two will dent the EM risk asset rally. Strong DM growth will not offset the impact of a slower Chinese economy on EMs and commodities. A new fixed-income trade: bet on a steeper swap curve in Mexico relative to Canada. Feature The global macro landscape in 2018 will be shaped by the two tectonic shifts: U.S. fiscal stimulus amid vigorous growth, and policy tightening in China amid lingering credit and money excesses. The former will grease the wheels of the already robust U.S. economy, generating a whiff of inflation and fueling a further selloff in the U.S. bond market. China's tightening will in turn weigh on commodities prices and curtail the emerging market (EM) economic recovery. A manifestation of these tectonic macro shifts will be a U.S. dollar rally and weakening commodities prices producing formidable headwinds to EM risk assets. As such, we are reiterating our recommendation to underweight EM risk assets versus their DM peers. As to the absolute performance, we believe EM risk assets are close to a major market top. A Whiff Of U.S. Inflation Strong U.S. growth could in fact be damaging to EM financial markets, as it will likely augment U.S. consumer price inflation. Investors are currently extremely sanguine on U.S. inflationary pressures. An upside surprise to inflation will lift U.S. interest rate expectations further, supporting the greenback and hurting EM carry trades. There is some evidence that U.S. inflation is about to pick up: The New York Federal Reserve underlying inflation gauge is rising, signaling higher inflation ahead (Chart I-1). The nascent revival in the MZM (money of zero maturity) impulse presages a trough in inflation (Chart I-2). Chart I-1Fed Price Pressure Gauge Signifies Higher Inflation Chart I-2U.S. Money Growth And CPI The weak U.S. dollar will also help augment inflation in America. U.S. import prices from emerging Asia and Mexico have been rising - even before the latest carnage in the U.S. dollar (Chart I-3). This will filter through into higher domestic price pressures. Chart I-3U.S. Import Prices Are Rising In brief, fiscal stimulus amid buoyant growth as well as overwhelming optimism among consumers and businesses is creating fertile ground for companies to raise prices. This will amplify corporate profit growth but will also lead to higher inflation. We are not making a case that U.S. inflation is about to surge. Our thesis is that market participants are very complacent on inflation. The money market is pricing in only 96 basis points in rate hikes in 2018-'19. In the meantime, the term premium in the U.S. yield curve is extremely depressed. Therefore, even modest inflation surprises will likely produce an additional meaningful selloff in U.S./DM bond markets. Will global share prices rise in response to strong corporate profit growth, or sell off in the face of higher U.S. inflation? Our hunch is that share prices will suffer as rising bond yields cause multiples to shrink. Rising bond yields will overpower the profit growth impact on share prices. The basis is that multiples are disproportionately and inversely linked to percentage change interest rates but are proportionately and positively linked to EPS.1 At still-low yields, a 50-basis-point rise in bond yields constitutes a sizable percentage change in the bond yield, likely leading to a meaningful P/E de-rating. Current sky-high bullish sentiment towards equities combined with elevated valuations and overbought conditions will mean that even a modest rise in inflation readings will likely trigger equity market jitters. EMs will underperform DMs amid such a selloff, as the former has benefited much more than the latter from low interest rates. Bottom Line: U.S. fiscal stimulus is arriving at a time when final demand is robust, the labor market is tight and business and consumer confidence is buoyant. This will encourage companies to raise prices, resulting in a whiff of U.S. inflation. The latter will rattle markets in the months ahead. China: Tightening Amid Credit/Money Excesses Inflation in China has already been steadily rising (Chart I-4). Interest rates adjusted for inflation remain low. Rising inflation along with still-lingering credit and money excesses necessitates policy tightening. We have written extensively about China's ongoing tightening trifecta - liquidity tightening, increased regulatory oversight and clampdown as well as an anti-corruption crackdown in the financial industry.2 Regulatory tightening in particular could inflict a particular bite as it outright constrains banks' ability to originate credit. This tightening has already led to record low broad money growth, and credit growth is downshifting too (Chart I-5). The cumulative impact of this tightening will play out in the months ahead, weighing further on money and credit growth and ultimately on final demand. Chart I-4China: Inflation Is In Steady Uptrend Chart I-5China: Broad Money And Credit Growth On the fiscal front, local government spending has languished in recent months (Chart I-6, top panel) and general (central plus local) government spending growth has been lackluster (Chart I-6, bottom panel). In 2017, local government annual spending amounted to RMB 19 trillion, or 22% of nominal GDP. Central government expenditures are about 6-fold smaller. Local governments rely on land sales to replenish their coffers, but timid money growth points to weaker land sales ahead (Chart I-7). In the meantime, their annual borrowing is restricted by the central government. Overall, this will constrain local government expenditures in 2018. Chart I-6China: Government Expenditures Chart I-7China: Land Sales To Slump The combined credit and fiscal spending impulse heralds a relapse in mainland imports of goods and commodities (Chart I-8). This constitutes a major threat to commodities prices, and consequently to EM. A pertinent question is whether financial markets will react to rising U.S. inflation or a slowdown in Chinese growth. Clearly, one could argue that strong U.S. growth would offset a mainland growth slump, resulting in a stable global macro environment. However, financial markets are an emotional discounting mechanism, and they do not always follow rational thinking. For example, in the first half of 2008 - just a few months ahead of the Global Financial Crisis - global financial markets were preoccupied with mounting global inflation due to strong growth in EM/China. At the time, oil and many other commodities prices were literally surging, and U.S. bond yields were climbing (Chart I-9). Global financial markets were not concerned with the ongoing U.S. recession, shrinking bank loans and deflating house prices. Chart I-8China's Impact On Rest Of The World Chart I-92008: An Inflation Scare Just ##br##Before Deflationary Bust In retrospect, financial markets traded on the theme of rising global inflation in the first half of 2008 even though the U.S. was already in a recession, and was heading into the most severe deflationary bust of the past 80 years. Similarly, the financial markets today could trade on the U.S. inflation theme for a couple months, even though China will be slowing. Bottom Line: China's policy tightening is particularly dangerous because it is occurring amid substantial and still-lingering credit, money and property market excesses. Won't Strong DM Growth Support China And Other EMs? Our investment stance on EM has been and remains negative, despite our positive view on U.S. and European growth. The key rationale for this stance is that EMs are much more leveraged to China than to the U.S. and Europe. Hence, our view assumes de-synchronization of growth between EM and DM. In our opinion, an EM slowdown will be largely due to China's deceleration and the latter's impact on commodities prices and non-commodity economies in Asia via trade. South America, Russia, South Africa, Malaysia and Indonesia are commodities producers, and as such are sensitive to fluctuations in commodities prices. The rest of Asia - Korea, Taiwan, Singapore, Thailand and the Philippines - are still exposed to the mainland economy as the latter is their largest export destination. Thus out of the EM sphere, China's dynamics will have a limited impact on only Mexico, India, and Turkey. However, Mexico is at risk of a NAFTA abrogation, while Turkey is at risk of runaway inflation and monetary profligacy. India on the other hand has its own problems and its bourse is unlikely to do well, given it is overbought and expensive. Furthermore, while we are bullish on the growth outlook in central European economies, they are too small to matter from an EM benchmark perspective. It might be useful to contemplate the late 1990s macro dynamics when major decoupling occurred between DM and EM. The booming economies of the U.S. and Europe did not prevent recurring crises in EM in the second half of the 1990s. Chart I-10 illustrates that U.S. and European imports growth was surging at that time, but EM stocks and currencies collapsed. What's more, despite the economic boom in DM during that period - U.S. and euro area real GDP growth rates averaged 4.2% and 2.6%, respectively, between 1996 and 1998 - commodities prices were in a bear market (Chart I-11). Chart I-10EM Crises In 1997-98: U.S. And ##br##Europe's Imports Were Booming Chart I-11Booming DM GDP And ##br##Falling Commodities Prices One might suspect that EM crises in the second half of the 1990s occurred because booming DM growth led to rising U.S. bond yields. However, Chart I-12 portrays that U.S. bond yields actually fell in 1997 and 1998 due to the deflationary shock stemming from the EM turmoil. Chart I-12EM Crises Occurred Amid ##br##Falling U.S. Bond Yields By and large, the 1997-98 EM crises occurred despite buoyant DM growth and falling DM bond yields. Nowadays, advanced economies carry much smaller weight in global trade and GDP than they did 20 years ago. Furthermore, EMs are much less dependent on exporting to DMs than they were two decades ago. In addition, China was not an economic powerhouse 20 years ago like it is today, and it did not buy as much from the rest of EMs as it does today. Presently, China holds the key to the EM outlook, and the link is through Chinese imports of goods and commodities. As China's credit and fiscal spending impulse suggests, mainland imports are likely to slow, weighing on commodities prices (refer to Chart I-8 on page 6). To be sure, we are not suggesting that EMs are facing crises similar to what transpired in 1997-98. The point of this comparison is to highlight that robust DM growth in of itself is not sufficient to head off an EM downturn if the latter faces a negative shock from China. With respect to DM growth benefiting China itself, it is critical to realize that China's exports to the U.S. and EU together account for only 6.6% of Chinese GDP (Chart I-13). By far, the largest component of the mainland economy is capital spending, constituting 42% of GDP. Construction and infrastructure are an integral part of capital expenditures, and they are very sensitive to money/credit cycles. Finally, from a global trade perspective, China and the rest of EM account for 46% of global imports, while the U.S. and EU account for 20% and 15%, respectively (Chart I-14). Hence, the total import bill of EM including China is larger than that of the U.S.'s and EU's imports combined. This entails that the pace of global trade growth is set to moderate if EM/China domestic demand decelerates. Chart I-13What Drives Chinese Economy: ##br##Capex Not Exports To DM Chart I-14Important Of EM/China In Global Trade Bottom Line: Strong DM growth will not offset the impact of a slower Chinese economy on EMs and commodities. Investment Conclusions A manifestation of the above-discussed tectonic macro shifts - a rise in U.S. inflation and China's slowdown - will be a U.S. dollar rally and weakening commodities prices. These two macro shifts will produce a perfect storm for EM risk assets. As a harbinger of a forthcoming selloff in EM exchange rates and DM commodities currencies (AUD, NZD and CAD), their implied volatility measures are already picking up (Chart I-15). As to a China/Asia slowdown, Korean, Taiwanese and Singaporean manufacturing output volume growth rates have already relapsed (Chart I-16). Their exports and corporate profits still appear robust because of rising prices. This certifies that there are inflationary pressures, even in Asia. Chart I-15Currency VOLs Are Rising Chart I-16Asian Manufacturing Output Volume All in all, we maintain a negative stance on EM risk assets in absolute terms and recommend underweighting them versus their DM peers. Within the EM universe, our equity market overweights are Taiwan, India, Korean technology, Thailand, Russia, central Europe and Chile. Our underweights are South Africa, Turkey, Brazil, Peru and Malaysia. Among currencies, our favorite shorts are the TRY, the ZAR, the MYR and the BRL. For investors who prefers relative EM currency trades, we recommend the following longs for crosses: RUB, TWD, THB, CNY and INR. For fixed-income trades, please refer to our open position table on page 18. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Mexico: Bet On A Steeper Swap Curve Relative To Canada For Mexican financial markets, the key uncertainty at the moment is the outcome of the ongoing NAFTA negotiations. Mexico's macro backdrop argues for considerable central bank easing, as inflation is about to roll over and domestic demand is extremely weak. However, if the U.S. pulls out of NAFTA - the odds of which are considerable, as our Geopolitical Strategy team has argued3 - the peso will sell off and interest rates are likely to rise. How should investors position themselves in Mexican fixed-income markets given this binominal outcome from the NAFTA negotiations and uncertainty over its timing? One way is to position for a swap curve steepening in Mexico, and hedge it by betting on a swap curve flattening in Canada by entering the following pair trades (Chart II-1): Chart II-1Mexico, Canada And Their ##br##Relative Swap Curve Receive 6-month and pay 10-year swap rates in Mexico Pay 6-month and receive 10-year swap rates in Canada In A Scenario Where The U.S. Withdraws From NAFTA: The Mexican swap curve would invert due to short-term rates going up more than long-term rates. In Canada, potential risks from NAFTA abrogation and tightening monetary policy amid frothy property markets and high household debt will cap upside in its long-term interest rates. With its long-term bond swap rates at par with those in the U.S., it seems as though the Canadian fixed income market is underpricing the risk of potential growth disappointments beyond the near run. In essence, should the U.S. withdraw from NAFTA, the loss realized on the Mexican steepener leg would partially be offset by the potential gain on the Canadian flattener leg. In A Scenario Where The U.S. Does Not Withdraw From NAFTA: The Mexican swap curve would start steepening. The rationale is that domestic dynamics suggest inflation has peaked and Banxico should begin its easing cycle soon. Monetary and fiscal policies have been extremely restrictive in Mexico, and considerable monetary easing is justified going forward: A significant part of the rise in inflation in 2017 was caused by peso depreciation in 2016. Last year's peso rally suggests that inflation should start to roll over soon (Chart II-2). Besides, one-off effects on inflation - such as the gasoline subsidy removal that took place at the end of 2016 - will subside as the base effect it has caused fades. In brief, the consumer inflation rate will rapidly decline, justifying substantial monetary easing. Banxico's 425 basis points in rate hikes since the end of 2015 are still filtering through the economy. The persistent slowdown in money and credit growth will continue to weigh on domestic demand for the time being. Notably, retail sales volume and gross fixed capital formation are both contracting while domestic vehicles sales are shrinking sharply (Chart II-3). Chart II-2Mexico: Inflation Is Set To Drop Chart II-3Mexico: Consumer And Business ##br##Spending Are Extremely Weak Due to currently high inflation, real wage growth remains weak. This will continue to weigh on consumer spending (Chart II-4). Fiscal policy has been tightening. Fiscal expenditures, excluding interest payments, are contracting in nominal terms (Chart II-5). Chart II-4Mexico: Real Wage Growth Is Very Timid Chart II-5Mexico: Fiscal Policy Is Super Tight Canada is currently on the opposite side of the business cycle spectrum relative to Mexico. The Canadian economy is very strong, being led by domestic demand. Real consumer spending is growing at its fastest pace in nearly 10 years, while the unemployment rate is at 40-year lows. Moreover, a record proportion of Canadian firms are having difficulty meeting demand because of capacity constraints and a tight labor market (Chart II-6, top and middle panel). Chart II-6Canadian Economy Is ##br##Above Full-Employment As such, the output gap is positive and growing, which has historically led to rising inflation (Chart II-6, bottom panel). Robust growth and rising inflation will force the Bank of Canada to hike rates further. In the meantime, real estate and consumer credit in Canada are overextended, leaving the Canadian consumer at risk from much higher interest rates. The threat that monetary tightening will hurt domestic demand in the future will cap the swap curve in Canada relative to Mexico. On the whole, in the scenario where the U.S. remains in NAFTA, the potential for swap curve steepening in Canada is less than in Mexico. Investment Recommendations We have been recommending that investors maintain a neutral stance across all asset classes in Mexico and wait for clarity on NAFTA negotiations before going overweight the country's currency, fixed-income markets and possibly equities relative to their EM peers. In the face of lingering NAFTA uncertainty, fixed-income investors should contemplate the following relative trade: Receive 6-month and pay 10-year swap rates in Mexico / pay 6-month and receive 10-year swap rates in Canada. Overall, this trade is exposed to minimal losses in the scenario where the U.S. withdraws from NAFTA but is exposed to considerable gains where the U.S. remains in NAFTA, making the overall risk/reward attractive. Provided the NAFTA negotiations could drag till year-end, this trade offers a reasonable risk-reward for traders. It offers a profitable opportunity to profit from Mexico's swap curve steepening, while limiting downside in case NAFTA is terminated before year-end. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com 1 This is due to the fact that interest rates are in the denominator of the Gordon Growth model while EPS/dividends are in the numerator. 2 Please refer to Emerging Markets Strategy Weekly Report, titled "Questions For Emerging Markets," dated November 29, 2017, the link is available on page 19. 3 Please refer to the Geopolitical Strategy Special Report, titled "Nafta - Populism Vs. Pluto-Populism," dated November 10, 2017, the link is available at gps.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights EUR/USD is in a blow off phase. Treasury secretary Mnuchin's comments added fuel to a fire already lit by worries of twin deficits and the inherent responsivity of the dollar to momentum. It is dangerous to short EUR/USD when momentum is so strong; while we expect EUR/USD to correct over the next three months, it is safer to short the euro against the yen. The rebound in Australia's national income will peter off, this will hurt inflows into the country. The RBA will not surprise markets to the upside in 2018. Most of the drivers of AUD/USD point south. Stay short the AUD against the CAD and NZD, shorting AUD/JPY is attractive. Feature By somewhat abandoning the "strong dollar policy" in Davos, U.S. Treasury Secretary Steve Mnuchin sent the dollar in yet another tailspin this week.1 The weakness was further compounded by the seeming lack of concern vis-à-vis the euro's strength expressed by European Central Bank President Mario Draghi during the European Central Bank's press conference in Frankfurt yesterday. Mnuchin's comments rightfully worried investors, as they echoed President Trump's own rhetoric from a year ago that a strong dollar was negative for the U.S. economy, at least in terms of trade competitiveness. However, it is important to remember that words are only words, and for these utterances to have any durable impact, they need to be backed by policy instruments. The 1985 Plaza Accord was able to drive down the dollar not just because finance ministers said that the greenback was too strong, but also because the Federal Reserve cut interest rates in half between July 1984 and October 1986. This drove 2-year yield differentials between the U.S. and Japan, the U.K., and Germany down by 454 bps, 630 bps and 407 bps, respectively. Compounding this punch, the USD was trading at prodigiously expensive levels in early 1985. Today, the Fed is not cutting interest rates, it is raising them. In fact, BCA expects at least three rate hikes this year. The current weakness in the dollar is also easing U.S. financial conditions further, which is giving more ammunition for the Fed to tighten policy. Meanwhile, President Draghi reiterated that the ECB was very unlikely to increase rates in 2018; thus rate differentials between the U.S. and the euro area are widening, not narrowing. There is also the nagging question of the twin deficit in the U.S. The Trump stimulus package is expected to increase the fiscal deficit, and also feed through to a higher current account deficit. We have sympathy for this view. While such a twin deficit was associated with a weakening USD at the beginning of the millennium, in the first half of the 1980s it was not. Thus a twin deficit is no guarantee of a weaker dollar. The behavior of the Fed is likely to once again dominate. In the early days of the millennium, the Greenspan Fed was easing policy aggressively. In the early 1980s, while the Fed was cutting rates, it was cutting rates at a slower pace than had been anticipated because it realized that President Ronald Reagan's tax cuts and increased military spending were inflationary. Volcker wanted to make sure inflation expectations would stay well anchored, and not spike up. It thus seems that once again, the behavior of U.S. inflation is paramount. If U.S. inflation picks up as we expect (Chart I-1), the dollar is likely to appreciate as the Fed will hike. If U.S. inflation stays moribund, the twin deficit will likely tank the dollar. What to do practically? We have posited that the expected terminal rate spread between the euro area and the U.S. has been the interest rate spread driving EUR/USD rate over the past 12 months. Yet, even by this metric, the move in the euro to 1.25 is out of bound, as the euro has completely diverged from the recent trends in terminal rate differentials (Chart I-2). This suggests the euro is vulnerable at current levels. Chart I-1U.S. Inflation Will Pick Up Chart I-2Mind The Gap! It is also important to remark that the dollar's weakness is generalized. Moreover, the dollar is oversold and likely to experience a rebound (Chart I-3). However, timing this rebound is a made harder by the nature of the greenback. As we highlighted in a Special Report in December, the U.S. dollar is one of the two currencies exhibiting the strongest response to momentum factors.2 This is because the dollar is a very important macro variable, which is both responsive to global growth but also a key input to global growth. As global growth strengthens, this tends to weigh on the USD, but the USD's weakness tends to also boost global growth, as it eases global financial conditions. This creates a strong feedback loop that favors momentum trades in the USD. Chart I-3The Time To Bet On A Rebound Is High The greenback is currently entangled in such dynamics. Global growth improved after China massively stimulated its economy in 2015 and early 2016, which hurt the dollar. The weakness in the dollar is now helping global growth, which further hurts the dollar. It is thus a mugs game trying to time a reversal in the USD. As a result, even if we think EUR/USD is likely to experience a sharp correction in the coming weeks, we prefer shorting EUR/JPY. EUR/JPY is expensive, and positioning is just as extreme. However, by shorting the euro against the yen, we are not as exposed to the dollar cycle, and if global growth were to weaken in response to increasing tightening in Chinese policy, the yen would benefit in this environment. As such, the risk-reward ratio for this trade is higher. Bottom Line: Mnuchin comments on the USD were only an excuse for the dollar to sell off. The true culprit for the dollar's weakness is the greenback's own extreme sensitivity to momentum. As a result, timing a dollar reversal is nearly impossible. Only once the dollar begins to turn around can we begin betting on a tactical USD rally, even if it dooms us to miss the early parts of the move. Shorting EUR/JPY continues to offer a more attractive risk-reward tradeoff than shorting EUR/USD. Feature: Hard Times Ahead For The AUD The Australian dollar has rallied by a stunning 18.3% since its February 2016 trough. Improvement in global trade, surging Chinese stimulus, the resurgence in commodity prices, the rally in EM stocks, and the fall in the U.S. dollar have all aligned to transform the AUD into a high flyer. Not only have these factors encouraged risk-taking, creating an environment that is helping high-beta Australian assets perform well, they also have had a direct positive outcome on the Australian balance of payments, thus creating real improvements in the AUD's fundamentals as well. With AUD/USD now back above the key 0.80 threshold, it is important for investors to ask themselves: Can the AUD continue on its upward trajectory or is it time to bet against it? While the short-term outlook remains clouded by the USD's downward momentum, the AUD is likely to weaken on a cyclical basis. Playing AUD weakness against the NZD, CAD, and JPY seems like safer bets at the current juncture. Australian Economic Developments Australia's real GDP growth has slowed from 2.8% in Q3 2016 to 2.2% in Q3 2017, and currently stands below the lows recorded in 2015. However, this hides some very significant improvements, as nominal GDP growth has surged - from 1.4% in Q3 2015 to 6.5% in Q3 2017 (Chart I-4). Consumption has not been the crucial source of variations in Australia's economic activity. Instead, the source of change has emanated from net exports, which have moved from slicing off nearly 2% to GDP growth in late 2015 to adding more than 3% in the most recent quarter. The fluctuations in Australian growth have in large part reflected the dynamics in commodities prices. Australia has undergone massive fluctuations in its terms-of-trade as iron ore, copper and coal prices experienced a bust, followed by a subsequent boom that has pushed base metals prices up by 76% since their nadir. These movements in commodity prices not only explain past gross domestic product performance, they also explain the swings in both national income and corporate profits (Chart I-5). Chart I-4Australian Growth Decomposition Chart I-5The Positive Shock: Commodities In response to the improvement in national income and profits since the winter of 2016, the basic balance of Australia has surged from a deficit of 3% of GDP to a surplus of 3% (Chart I-6). While higher commodities prices contributed to higher exports, lifting the current account, portfolio flows moved up by more than 4% of GDP. This was simply because the surge in Australian corporate profits also made investing in Australia much more attractive for investors around the world. This combination caused a lot of investors to buy Australian dollars in the process, generating a severe upward bias in favor of the AUD. But how these trends are likely to evolve remains uncertain. To begin with, the rate of change of the Reserve Bank of Australia's commodity index has already rolled over, plunging from a high of 47% six months ago to -1% today. The historical lead times of this variable on GDP, GNI and profits suggests that each of these three variables are set to decelerate meaningfully in the coming quarters. This could weigh on inflows into Australia. China too plays a key role. Exports to China were subtracting 0.5% from Australia's growth as of the end of 2016 and are now adding 1.5%. Swings in Chinese activity could amplify the impact of the rollover in commodities price inflation. In fact, the slowing Li Keqiang index already paints this exact picture (Chart I-7). The growth rate of railway freight, one of the index's components, has already collapsed from 20% in August 2017 to 1%, and iron ore stockpiles in Chinese ports are hitting record highs. The tightening of the monetary and fiscal screws in China are therefore likely to exert a negative impact on Australia's national income, and thus on inflows that have been so important in supporting the AUD. Chart I-6From Income Shock To ##br##Balance Of Payment Shock Chart I-7China's Boost Is Dissipating ##br##The Boost To Trade Is Dissipating But what about real economic activity? Here again, the picture does not shine particularly bright. Fiscal policy has been a drag on GDP since 2011, and 2018 will be no exception, as the fiscal thrust will be -0.3% of potential GDP (Chart I-8). A potential rollover in aggregate profits could limit corporate capex in 2018. Mining projects in Australia are expected to continue to decline as a share of GDP in 2018, thus mining capex will remain a drag on growth (Chart I-9). Moreover, imports of capital goods have been a leading indicator of Australian capex, and they too have rolled over after a recent surge, suggesting that non-mining capex growth will also experience limited upside. The Australian consumer is also unlikely to come and save the day. To begin with, the savings rate has additional upside. As net worth has increased, Australian households have curtailed their savings rate to 3% of disposable income (Chart I-10). Moreover, debt levels have increased significantly, rising to an eye-opening 200% of income. The problem is that Australian housing is now much overvalued (Chart I-11). While this does not guarantee a fall in house prices, it is highly unlikely that net worth will continue to increase at its heady pace. Thus, with high debt loads and a limited wealth effect, the probability is high that the savings rate will increase. Chart I-8Fiscal Policy: Still Contractionary ##br## Fiscal Policy Is Still A Drag Chart I-9Mining Capex##br## Still Falling Chart I-10Households Savings ##br##Rate Should Rise Put together, the Australian economy is unlikely to accelerate this year. As Chart I-12 illustrates, business confidence has been weakening throughout the year, new orders are at high levels but are rolling over, and real consumer spending has not been able to gain any traction - despite job growth reaching a 3.8% annual pace. Job growth is unlikely to accelerate from such high levels, limiting the potential for household income growth to undo the damage of a rising savings rate. Chart I-11House Price Gains Will Slow Chart I-12No Boost To Real GDP Growth Bottom Line: The Australian dollar has benefitted from a major nominal improvement in the economy. As terms of trade rebounded, so did nominal GDP, national income and profits. This caused a surge in inflows into the country. However, the best of the positive terms-of-trade shock is ebbing, and the slowdown in Chinese industrial activity also points to weakening national income growth. In terms of real activity, the Australian fiscal drag continues unabated, capex will not accelerate, and households are likely to increase their savings rate, which will weigh on consumption. While Australia is not on the verge of recession, it will not experience much of a boom either. But How Fast Can The RBA Hike Anyway? Chart I-13The RBA Is Limited By Economic Slack The RBA is also still facing a tough environment. On one hand, job creation was very robust in Australia last year, and core CPI has accelerated. However, wage growth remains depressed at 2%. Even more disturbing is the fact that Australian wages have decoupled from a reliable driver: exports to China (Chart I-13). This underscores the extremely large degree of slack present in the Australian labor market. As the middle panel of Chart I-13 displays, the underemployment rate remains near twenty five-year highs and is congruent with the current level of wage growth. Moreover, Australia's output gap is still -2% of GDP and is not expected to close until after 2020. Thus, the underemployment rate will continue to act as an anchor on policy (Chart I-13, bottom panel). The strength in the AUD since 2016 will play into these dynamics. The lack of traction on wages is likely to be compounded by the tightening in monetary conditions resulting from an expensive AUD. As such, we would expect core CPI to weaken again in the coming quarters, which will comfort the RBA that its dovish stance remains appropriate. Finally, the high indebtedness of Australian households along with the fact that house price appreciation has slowed also suggests that household balance sheets are not capable of withstanding much of an increase in interest rates right now. The RBA is unlikely to toy with such a deflationary risk while the output gap is still negative and labor utilization is so low. The market is currently pricing in 40 basis points of hikes in 2018. A hike in 2018 is possible, as the global economy has healed from its deflationary nadir of 2016, but the economic backdrop of Australia will not let the RBA test the waters more than once this year. We thus anticipate that the RBA will continue to lag the Bank of Canada and the Federal Reserve - two central banks we expect to raise rates three times in 2018. The RBA will also most likely lag behind the RBNZ. Bottom Line: The Australian economy is replete with excess capacity, which is limiting the ability of the RBA to push up its policy rate. Moreover, the elevated indebtedness of Australian households suggests the RBA is loath to generate a deflationary shock while the output gap is already negative. The RBA will therefore lag the Fed, the BoC and the RBNZ. Implications For The AUD AUD/USD is currently trading at a 15% premium to its purchasing power parity equilibrium versus the U.S. dollar, making it one of the rare currencies expensive against the still-pricey greenback (Chart I-14, top panel). Moreover, Australia's real effective exchange rate also trades above its long-term average (Chart I-14, bottom panel). While the AUD is not wildly expensive, its current premium to fair value does suggest it would not be immune to adverse cyclical dynamics. What do the cyclical drivers currently say about the AUD? As we have highlighted, Australian national income and profit growth are likely to decelerate sharply in 2018, which is likely to undo some of the improvement that has materialized in the basic balance and thus remove one of the key supports that has underpinned the AUD. In this optic, the fact that the AUD has been able to strengthen despite a significant deceleration in Australian exports of iron ore to China raises a yellow flag against the AUD's strength (Chart I-15). Chart I-14No Valuation Cushion In AUD Chart I-15AUD Disconnect However, when investors expect strong growth from EM economies, the AUD does well. Thus, if the outlook for EM growth remains healthy, current weaknesses in commodities shipments can be safely ignored. Under this framework, the recent sharp upgrade by global investors of long-term earnings growth of EM equities sheds light on the AUD's strength, despite slowing iron ore exports (Chart I-16). Yet, this growth expectation is now the highest on record. This suggests the expectation hurdles in EM are very elevated. Even if EM growth does not crater, any disappointment could leave the AUD in a vulnerable position. The rollover in the annual performance of EM/JPY carry trades point to a growing risk of such disappointments.3 Financial markets are also sending interesting signals. Australian equities are underperforming global indices in local currency terms, suggesting the growth outlook for Australia is weakening relative to the rest of the world. These developments are true even when financial stocks are removed from the equation. Moreover, AUD/USD has historically traded in line with the relative performance between Australian and U.S. equities. Not only is the AUD currently quite above the level implied by the relative stock performance, but also the underperformance of Aussie stocks is deepening. This is another poor omen for AUD/USD (Chart I-17). Chart I-16Investors Love EM, ##br##This Helps The Aussie Chart I-17Listen To Equities If stocks are sending a message regarding the path of the Australian economy vis-à-vis the U.S., and thus about the outlook for AUD/USD, so are various key drivers of policy. First, AUD/USD normally broadly tracks the gap in the five-year moving average of nominal GDP growth between Australia and the U.S. This growth differential is moving in the opposite direction of AUD/USD, and based on the IMF's forecast, it is only expected to widen. AUD/USD has also been responsive to the relative utilization of labor, as measured by the spreads between the U.S.'s U-6 unemployment rate and Australia's labor underemployment measure (Chart I-18). Currently, this spread is not ratifying the rally in AUD/USD - and is pointing toward a much more hawkish Fed than RBA. This too paints a somber picture for the Aussie. This picture is echoed by the trend in Australia's employment-to-population ratio for prime age workers relative to the U.S. Again, Australia's large labor market excess supply points to a weaker AUD (Chart I-19, top panel). What's more, Australia's employment-to-population ratio is set to fall further vis-à-vis the U.S. This relative labor utilization measure has tracked the share of investment as a percent of Chinese GDP. This is because the investment-heavy period of development that China has undergone over the past 30 years has been very commodities intensive, forcing full labor utilization in Australia. However, based on the IMF's forecast, the role of investment in the Chinese economy is set to decline further (Chart I-19, bottom panel). Chart I-18Labor Market Slack Points To Weak AUD Chart I-19Labor Market And China Additionally, Xi Jinping's reforms are about decreasing pollution and leverage while increasing the role of consumption and services in the economy. This points to a risk of an even greater fall in the share of capex in China's economy. This would deepen the decline in labor utilization in Australia relative to the U.S., and thus increase downside risk for the AUD. Another risk emanates from U.S. financial markets themselves. The AUD tends to perform well when volatility in financial markets is on the decline, or at very low levels. This describes the current state of financial markets. On the other hand, a higher VIX is associated with a declining AUD. The VIX's current low level is not enough to flash an imminent sell signal, but the risk of a spike in risk aversion increases significantly if the spot VIX is low and the VIX futures curve is "too flat." Since there is a strong inverse relationship between the VIX futures curve slope and the spot VIX, the curve is "too flat" when its steepness is below the degree implied by the line of best fit linking the slope to spot VIX. As Chart I-20 shows, when the slope of the VIX is below this implied fair value, the subsequent 12 months of returns in the AUD/USD have been negative 84% of the time. The current reading in this relationship suggests that the AUD could depreciate by a large amount over the coming year. Chart I-20Flat VIX Term Structure = Lower AUD In 12 Months Bottom Line: Australia's national income growth is set to decline, and the RBA is unlikely to increase rates more than is currently priced into the curve. Moreover, the Australian dollar is trading on the expensive side. These factors point to vulnerability for the AUD. Moreover, key variables are suggesting this vulnerability could materialize into actual weakness: investors are pricing in too much growth in the EM space, Australian equities point to growth underperformance, labor market utilization measures suggest relative policy will hurt the AUD, China's long-term policy tilt is becoming increasingly AUD-negative, and any spike in asset volatility would hurt the Aussie. Strategy Considerations The arguments highlighted above all point to a weakening AUD. However, the picture is never that clear-cut. In fact, there is one major risk to our view: commodities prices and the USD itself. As Chart I-21 illustrates, commodities prices have a stronger inverse relationship with the USD than they have a positive link to Chinese economic conditions. Thus, if the greenback were to weaken further, the AUD could delay its moment of reckoning even further. This suggests that playing AUD weakness on its crosses, while potentially less rewarding, is a safer strategy. Our long-term valuation models continue to highlight the positive risk/reward tradeoff to shorting AUD/NZD: Not only is the New Zealand economy less exposed to shifting away from investment in the Chinese economy, AUD/NZD is trading at valuation levels that are historically followed by periods of pronounced weakness (Chart I-22). Moreover, the Kiwi economy is displaying a much higher level of resource utilization than Australia, suggesting there is more scope for the RBNZ to increase rates than there is for the RBA. Chart I-21Risk To The View: The Weak USD Chart I-22Improve Your Reward To Risk: Short AUD/NZD The same can be said about AUD/CAD. AUD/CAD also trades at a significant premium to its fair value. As we argued two weeks ago, like New Zealand, labor and capacity utilization in Canada are both very tight, thus we foresee three BoC rate hikes this year, which is at least two more than we anticipate in Australia. Additionally, our commodity strategists continue to like energy more than they like metals. Thus, terms-of-trade dynamics will play in favor of the CAD. That being said, this trade is much more correlated with the movements in AUD/USD than the AUD/NZD bet is. Shorting AUD/JPY is also an attractive trade right now. AUD/JPY is trading at a 30% premium to purchasing power parity, and the risk represented by a potential removal of over-exuberance currently evident in the pricing of growth in EM markets would likely be amplified in this cross. Additionally, as we highlighted two weeks ago, the risk of a tactical rally in the JPY is growing significantly. Bottom Line: The outlook is negative for AUD/USD, but if the USD's bear market can gather force from current levels, this would dampen the attractiveness of shorting the Aussie. While potentially less profitable but also considerably less risky, shorting AUD/NZD and AUD/CAD remain attractive expressions of our negative AUD bias. We also like going short AUD/JPY as it plays both on our positive tactical view on the JPY and on the risks of a slowdown in EM earnings growth expectations. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Even if he somewhat retracted his comments later during the day. 2 Please see Foreign Exchange Strategy Special Report, titled "Riding The Wave: Momentum Strategies In Foreign Exchange Markets," dated December 8, 2017, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report, titled "Canaries In The Coal Mine Alert: EM/JPY Carry Trades," dated December 1, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S. data was mixed: The Chicago Fed National Activity Index underperformed expectations of 0.44, coming in at 0.27; The Richmond Fed Manufacturing Index came in at 14, well below the expected 19; Manufacturing PMI came in at 55.5, above the consensus of 55; Existing Home Sales contracted by 3.6% on a monthly pace; New Home Sales contracted by 9.3% on a monthly pace; Continuing jobless claims underperformed at 1.937 million, while initial jobless claims outperformed expectations at 233,000. The greenback has experienced notable downside this week owing to a slew of disappointing data and significant technical breakdowns. Treasury Secretary Steven Mnuchin's comments concerning a weaker dollar being beneficial for growth only added fuel to the fire. We have a neutral view on the greenback against the euro as emerging inflation in the U.S. later in the year should help alleviate some of the gains in the euro. Report Links: A Cold Snap Doesn't Make A Winter - January 5, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 European data this week was stellar: German Current Situations and Economic Sentiment ZEW Surveys came in at 95.2 and 20.14, outperforming the expected 89.8 and 17.8; Overall euro area Economic Sentiment ZEW Survey came in at 31.8, outperforming the expected 29.7; European consumer confidence also beat expectations of 0.6, coming in at 1.3; German IFO Business Climate and Current Assessment outperformed expectations, while the Expectations survey underperformed; German Gfk Consumer Confidence came in at 11, also surpassing expectations of 10.8. Mario Draghi affirmed his positive outlook on European growth and inflation. However, we believe that the most recent move to 1.25 is unsustainable as the euro continues to decouple from relative terminal rates. We believe that signs of weakening global growth should translate into a weaker euro in the short term. Report Links: The Unstoppable Euro - January 19, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 A Cold Snap Doesn't Make A Winter - January 5, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: Even if they decelerated relative to the previous month, imports yearly growth surprised to the upside, coming in at 14.9%. Moreover, the Nikkei Manufacturing PMI also outperformed expectations, coming in at 54.4. The All Industry Activity Index month-on-month growth also outperformed, coming in at 1%. However, exports yearly growth, surprised to the downside, coming in at 9.3%. The Bank of Japan left the reference rate unchanged at -0.1%. In their Outlook for Economic Activity and Prices, the BoJ stated that it expects inflation to reach the 2% target by 2019. Moreover, the committee highlighted that the output gap will move further into positive territory in 2018 and 2019. Overall, we expect for the yen to appreciate in coming months, particularly against the Euro, given that financial conditions have tightened much more in Europe than in Japan. Report Links: Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Riding The Wave: Momentum Strategies In Foreign Exchange Markets - December 8, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: Retail sales and retail sales ex-fuel yearly growth both underperformed expectations, coming in at 1.4% and 1.3% respectively. Both of these measures also declined relatively to last month. Moreover, the claimant count change surprised negatively, coming in at 8.6 thousand. However, average earnings excluding bonus yearly growth outperformed expectations, coming in at 2.4%. This number also increased from 2.3% last month. GBP/USD has surged by almost 4% this week, partly due to the fall in the dollar. However the pound has also rallied against the euro, with EUR/GBP falling by almost 2%. Overall, the ability for the BoE to raise rates relative to other central banks will be limited, as the strengthening currency should create a drag on inflation and the economy displays underlying weaknesses. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The Australian dollar has benefitted from last year's stellar growth period, now above the crucial 0.80 level. Slowing Chinese industrial activity and a domestic fiscal drag will handicap Australian growth this year. We believe the AUD is expensive amongst various metrics and the RBA is unlikely to hike any time soon given the negative output gap. Additionally, substantial labor market slack remains as the concentration of employment has been in part-time growth. We believe markets are overpricing hikes at 40 bps, and the AUD will suffer once this becomes priced in. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data In New Zealand has been mixed: The ANZ Activity Outlook was unchanged from last month, coming in at 15.6%. However, headline inflation surprised to the downside, coming in at 1.6%. It also declined significantly from last month's 1.9% value. Intraday, the kiwi fell by almost 1.5% following the weak inflation number. However even amid this drop NZD/USD has rallied by almost 1% this week, as the dollar has weakened to its lowest level in 3 years. Overall, we are positive on this cross relatively to the AUD, given that Australia is more sensitive to a slowdown in China than New Zealand. However, the New Zealand dollar will likely have downside against the yen. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Data out of Canada was mixed: Wholesale sales monthly growth missed expectations of 1%, coming in at 0.7%; Headline retail sales missed expectations of 0.7%, coming in only at 0.2% on a monthly basis; Core retail sales (ex. Autos) outperformed the expected 0.8% greatly, coming in at 1.6% month-on-month; We remain bullish on CAD as strong employment and higher wages will augur well for inflation this year. Higher oil prices will continue to power the Canadian economy and help close the output gap in line with expectations. The Bank will therefore continue to tighten policy. Report Links: Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 EUR/CHF has fallen this week by almost 0.5% even as the euro has rallied. Nevertheless, as long as the SNB continues with its ultra-dovish monetary stance, upside for the franc is limited, as the Swiss National Bank will continue to intervene in the currency markets. Indeed, on Monday SNB president Thomas Jordan once again reiterated that he believed that the franc was "Highly Valued". As of now, while inflation is slowly picking up, wage growth and house price growth are too anemic for the SNB to have a significant change in their monetary stance. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 USD/NOK has depreciated by 2.2% this week, as it has been struck by a double whammy of higher oil prices and a very weak dollar. Meanwhile, on Wednesday, the Norges Bank decided to keep its key interest rate unchanged at 0.25%. The bank decided that monetary policy should stay accommodative for the foreseeable future, as inflation is likely to stay under target. Furthermore they stated that inflation, the economy, and the currency were evolving according to their December 2017 expectations. Overall, we expect the krone to appreciate relative to the Canadian dollar, as the BoC is fully priced this year, while the Norwegian interest rates could still have some upside amid rising oil prices. Report Links: Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Data out of Sweden was mixed: Consumer confidence decreased to 107.2 from 107.7, under expectations of 107.4; The unemployment rate increased to 6% from 5.8%, but beat expectations of 6.1%; Producer prices increased in December at a 1.6% monthly pace, and a 2.3% yearly pace. The SEK has appreciated noticeably given the recent hawkish comments by Riksbank officials about the policy path. While the consensus does seem to be changing in the Bank, we remain cautious given Ingves' dovish leanings. SEK could weaken against EUR for the rest of the year given Europe's stellar growth momentum. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 The Xs And The Currency Market - November 24, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades