Monetary

Special Report

Feature Recently we have received a number of client questions about the Fed's balance sheet. When will the Fed start to shrink its balance sheet (if at all)? If the Fed does decide to shrink its balance sheet, how long will that process take? How will the Fed control interest rates in the years ahead? And most importantly, how will these decisions impact financial markets? To answer these questions, this week we are sending you a Special Report titled "Cleaning Up After The 100-Year Flood" that was first published on June 10, 2014. This report explains how monetary policy is conducted at an operational level, and also how the dramatic expansion of the Fed's balance sheet forced the Fed to modify its approach. But first, we have some additional thoughts on how the Fed's balance sheet is likely to evolve during the next few years. The Fed's Stated Plan The most up-to-date guidance we have received about the Fed's balance sheet plans comes from Janet Yellen's recent Congressional testimony: The FOMC has annunciated that its longer run goal is to shrink our balance sheet to levels consistent with the efficient and effective implementation of monetary policy. And while our system evolves and I can't put a number on that, I would anticipate a balance sheet that's substantially smaller than at the current time. In addition, we would like our balance sheet to again be primarily Treasury securities, whereas as you pointed out, we have substantial holdings of mortgage-backed securities. From this, and similar statements from other Fed officials, we conclude that the Fed will allow its balance sheet to shrink once the fed funds rate is somewhere in the range of 1% to 1.5%.1 Surveys also show that the median primary dealer expects the Fed will change its balance sheet policy when the target fed funds rate is 1.38%. As such, and under reasonable assumptions for the pace of rate hikes, we think it is very likely that the Fed will start to let its balance sheet shrink sometime in 2018. MBS First, Treasuries Maybe Later Yellen's statement to Congress also makes clear that the Fed would be more comfortable with a balance sheet that consists entirely of Treasury securities. For this reason, the central bank will start by simply ceasing the reinvestment of its Agency bond and MBS portfolios. At least initially, the Fed will continue to reinvest the proceeds from its maturing Treasury portfolio. Yellen also left open the possibility that reinvestment could be "tapered" rather than just halted altogether. While this is possible, and in fact 70% of primary dealers think that reinvestments will be phased out over time while only 14% think they will be ceased all at once, it seems to us like a needless complication. We expect that reinvestments of Agency bonds and MBS will end all at once sometime in 2018. As for the Fed's holdings of Treasury securities, it is much less clear whether the Fed will allow these balances to run down. The accompanying Special Report describes in detail the differences between the Fed's pre-crisis mode of operation, when bank reserves were scarce, and the Fed's current mode of operation with large bank reserve balances. As of now, the Fed has stated that it intends to eventually drain bank reserves from the system and return to its pre-crisis mode of operation, but there are several possible advantages to running a system with an outsized Fed balance sheet and large bank reserve balances. Chart 1Reserves Can Be Drained Fairly Quickly None other than Ben Bernanke pointed out a few of those reasons in a blog post last fall.2 In our view, the most compelling is that regulatory changes have increased private sector demand for safe, short-maturity, liquid assets in recent years. If the Treasury department is unwilling to supply T-bills in sufficient numbers, then the Fed can supply safe, short-maturity, liquid assets to the market by purchasing long-maturity Treasury securities and replacing them with bank reserves. Of course, we take the Fed at its word when it says that it would like to eventually drain excess bank reserves from the system. But even in that case, the steady growth of currency in circulation means that bank reserves will decline over time even if the Fed keeps the asset side of its balance sheet flat. For example, Chart 1 shows what would happen to bank reserves if the amount of currency in circulation grows at a conservative 5% per year pace, and if the Fed decides to allow its Agency bond and MBS portfolios to run off at the beginning of next year while keeping its Treasury portfolio flat. We assume that MBS runs off the Fed's balance sheet at a pace of $15 billion per month, slightly below the recent pace of MBS reinvestment. During the past three years, the Fed has reinvested between $20bn and $40bn MBS each month with an average monthly reinvestment of $32bn. In this scenario, outstanding bank reserves would decline to zero by the end of 2025. At that point the Fed would have to start adding to its Treasury holdings just to keep pace with the amount of currency in circulation. Bottom Line: While it is very likely that the Fed will allow its Agency bond and MBS portfolios to run off starting in 2018, it is much more uncertain whether it will ever cease the reinvestment of its Treasury holdings. If the Fed does allow its Treasury holdings to run down as well, it will have to start buying Treasuries again before 2025. Investment Implications Treasuries As our U.S. Bond Strategy service has written several times,3 considered in isolation it is unlikely that any decision by the Fed to allow its Treasury holdings to run off will have much of on an impact on the Treasury curve. To see why, we need to consider the process by which the Fed currently rolls over maturing Treasury securities at auction. At the moment, balances of matured Treasury securities are added to upcoming note/bond auctions as non-competitive bids. In other words, as Treasury securities mature the Fed buys an equal amount at upcoming Treasury auctions. If the Fed were to cease this reinvestment, that amount would need to be added to the competitive portion of the auctions and would greatly increase the gross issuance of Treasury debt to the public. For a sense of scale, we calculate that Treasury issuance to the public would need to increase by $426bn in 2018 and $378bn in 2019 if the Fed were to cease the reinvestment of its portfolio at the end of this year (Chart 2). However, the fact that this process is intermediated by the Treasury department means we also have to consider potential changes to fiscal policy and the U.S. government's financing mix. For instance, since running down the Fed's Treasury portfolio would also reduce the amount of bank reserves in the system, it is very likely that the Treasury department would seek to increase issuance of T-bills to compensate for the banking sector's loss of safe, short-maturity liquid assets. At present, bill supply as a percent of total Treasury debt is near a multi-decade low (Chart 3) and any increase in T-bill issuance would limit the impact of Fed balance sheet run-off on long-dated Treasury yields. Chart 2Fed Runoff Will Increase Issuance To Public... Chart 3... But Mostly Through T-Bills Bottom Line: When forecasting Treasury issuance and any potential impact on yields we must consider both the Fed's balance sheet and fiscal policy together. In our view, whatever the government's financing requirement in the years ahead, a considerable portion will be met through increased T-bill issuance, limiting the impact on long-dated Treasury yields. Mortgage-Backed Securities As our U.S. Bond Strategy service has recently written,4 the unwinding of the Fed's MBS portfolio poses a considerable threat to MBS spreads for two reasons. First, the transfer of MBS from the Fed to the private sector will put upward pressure on implied volatility. While private investors often hedge their MBS positions by purchasing volatility, the Fed has no incentive to do so. It follows that by removing a large stock of MBS from private hands the Fed has also removed a large source of demand for volatility. When this supply is re-introduced into the market, demand for volatility will increase pressuring MBS spreads wider (Chart 4). The second reason relates more directly to the supply and demand balance for MBS. In years when net MBS issuance (adjusted for Fed purchases) has been negative, excess MBS returns have tended to be positive (Chart 5). Further, while negative net MBS issuance (adjusted for Fed purchases) has been the norm since Fed asset purchases began in 2009 (Chart 6), this state of affairs will change once the Fed starts to unwind its MBS portfolio. Chart 4MBS Spreads Are##br## Linked To Vol Chart 5Annual MBS Excess Returns##br## Vs. Net Supply Since 1989 Chart 6Adjusted Net Issuance Will ##br##Turn Positive In 2018 Bottom Line: The unwinding of the Fed's MBS portfolio will pressure MBS spreads wider through increased supply and increased demand for volatility. Note: Please see the U.S. Bond Strategy Special Report, titled "Cleaning Up After The 100-Year Flood", dated June 10, 2014 available at usbs.bcaresearch.com Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 In a Q&A from June 2015 New York Fed President William Dudley floated 1% to 1.5% as a potentially reasonable range for the fed funds rate before the Fed considers changing its balance sheet policy. https://mninews.marketnews.com/content/feds-dudley-qa-markets-should-not-be-surprised-liftoff 2 https://www.brookings.edu/blog/ben-bernanke/2016/09/02/should-the-fed-keep-its-balance-sheet-large/ 3 Please see U.S. Bond Strategy Weekly Report, "Is It Time To Cut Duration?", dated January 17, 2017. And also U.S. Bond Strategy Weekly Report, "Currencies: The Tail Wagging The Dog", dated August 18, 2015. Both available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "The Road To Higher Vol Is Paved With Uncertainty", dated February 14, 2017, available at usbs.bcaresearch.com Cleaning Up After The 100-Year Flood In this Special Report we consider how the dramatic expansion of the Fed's balance sheet has influenced the conduct of monetary policy from an operational perspective. Massive reserve balances have made the federal funds market largely irrelevant, but the Fed's new overnight reverse repo facility will allow it to tighten policy when the time comes. The Fed will likely provide new guidelines for its exit strategy before the end of 2014. We anticipate how these guidelines will be modified to reflect the challenges of implementing monetary policy with a large balance sheet. Large reserve balances do not pose an inflation threat, but they do have implications for the state of banking sector regulation and the policy tools at the Fed's disposal. Chart 1What Are Implications Of Fed's Epic Intervention? Feature The Federal Reserve resorted to a number of very aggressive and extraordinary monetary policy measures to deal with the failure of Lehman Brothers, the subsequent financial crisis and Great Recession. The result has been a flood of liquidity that has supported asset prices and spurred the recovery, yet has left the central bank balance sheet exponentially larger than at any time in its 100-year history (Chart 1). In formulating its exit strategy the Fed will finally be forced to grapple publicly with the aftereffects of its dramatic intervention in financial markets, which has complicated how monetary policy is implemented at an operational level. This Special Report is divided into three sections. In the first section, Before The Storm, we provide some background on the process of money creation and explain how the Fed implemented monetary policy prior to the Great Recession. In the second section, The Flood Waters Rise, we consider how monetary policy is implemented today in light of the dramatic expansion of the Fed's balance sheet. In the third section, Building On Higher Ground, we examine the way forward for the Fed, describe how the exit is likely to be managed and discuss the potential problems with this approach. 1. Before The Storm Prior to the financial crisis, the Fed expressed the stance of monetary policy via a target for the federal funds rate. The federal funds rate is the rate at which banks borrow and lend reserves to each other in the overnight market. The Fed conducted its day-to-day operations with the goal of supplying all the reserves demanded by the banking sector, while steering the fed funds rate toward its target. To understand how this was accomplished, we first require some background on the money creation process. Money Creation: More Than Just A Printing Press Contrary to what many believe, the process of money creation does not begin at the Federal Reserve. Rather, it begins in the banking system at the point of loan origination and ends at the Fed (Figure 1). The process is set in motion when a bank makes a new loan. This loan creates a new asset on the aggregate balance sheet for the banking system. The newly created money typically ends up as a deposit, either at the same bank or elsewhere in the banking system.1 The increase to the asset side of the banking sector's balance sheet is offset by an equal increase on the liability side. Only then does the Fed enter the picture. In a fractional reserve system, banks must hold reserves equal to a proportion of their deposits. Therefore, in the pre-QE world illustrated in Figure 1, any increase in deposits also creates demand for more reserves. Crucially, only the Fed is able to supply the banking sector with the needed reserves. The Fed will increase the supply of reserves either by purchasing Treasury securities or lending money in the repo market. This increase on the asset side of the Fed's balance sheet is balanced by an increase in reserves on the liability side. The creation of new bank reserves is the final step in the money creation process. Figure 1The Money Creation Process Chart 2QE Has Not Encouraged Lending This is not to suggest the Fed is powerless to control the rate of money creation. On the contrary, Fed policy is the most influential determinant of the rate of money growth. One important distinction, however, is that the Fed exerts control over the pace of money creation because it controls the overnight interest rate. The interest rate, in turn, is the most important driver of bank lending. Changes in the level of bank reserves not associated with changes in interest rates, QE for example, have no effect on credit growth (Chart 2). The Pre-Crisis Fed Funds Market How then, prior to the Great Recession, was the Fed able to maintain the fed funds rate at its target, while still satisfying the banking system's demand for reserves? It accomplished this task by maintaining what it calls a "structural deficiency" in the supply of bank reserves. In practice this means the Fed was careful to supply no more than the quantity of reserves demanded, so that each day it would typically add to the reserve supply to accommodate the newly created demand. As a practical matter, the Fed increases the supply of reserves by either buying securities or lending money in the repo market. Both of these transactions enter the Fed's balance sheet as an asset, which must be offset by a liability, in this case an increase in bank reserves. The Fed can also reduce the supply of reserves by either selling securities or borrowing in the repo market (using the securities it owns as collateral, deemed a reverse repo from the point of view of the borrower). Although due to the "structural deficiency" in the reserve market, the Fed would typically transact to increase reserve balances. Chart 3The Pre-Crisis 'Channel System' If, for example, the Fed wanted to increase the fed funds rate. It would be slow to accommodate the increase in demanded reserves throughout the day. Banks in need of reserves to meet intra-day payment processing needs would bid up the fed funds rate towards the new target. Effective communication of the target fed funds rate also aided this process. Since the target for the fed funds rate was known in advance, and the banking sector believed the Fed would supply all necessary reserves at that target rate, most federal funds transactions tended to occur at rates very close to the target. By the end of the day, however, the Fed must always supply the exact amount of reserves demanded by the banking sector if it wants to maintain control of the fed funds rate. If the Fed were to supply more reserves than the banking system required, banks would try to lend the unwanted excess reserves in the fed funds market, driving the federal funds rate lower to the interest rate paid on excess reserves (IOER), which was zero prior to 2008. Or, consider the opposite case where the Fed supplies too few reserves. In this instance banks would clamor to borrow reserves to meet their regulatory requirement. This incremental demand would drive the federal funds rate higher to the Fed's discount window lending rate, which is always available for banks to access in times of severe stress. The IOER and discount window rate thus created a channel for the fed funds rate (Chart 3), within which the Fed could nudge the rate toward target by being either too quick, or too slow to accommodate increases in demanded reserves throughout the day. Bottom Line: A "structural deficiency" in reserve balances prior to 2008 allowed the Fed to conduct monetary policy by setting a target for the fed funds rate. Also, it is the level of interest rates, and not the level of reserves, that determines the rate of money creation in the economy. 2. The Flood Waters Rise The Federal Reserve began large scale asset purchases (quantitative easing) in late 2008, dramatically increasing the asset side of its balance sheet and consequently the supply of bank reserves (Figure 2). Suddenly, the banking system found itself with far more reserves than it demanded. Predictably, trading in the fed funds market dried up and the fed funds rate was driven toward its lower bound, the IOER.2 The Fed's target for the federal funds rate quickly became irrelevant. Figure 2Illustrative Post-Crisis Balance Sheets For The Fed And The Aggregatve Banking System*: ##br##An Explosion In Excess Reserves In the presence of excess bank reserves, the Fed needs a mechanism to control the lower bound of overnight lending rates. In theory, the IOER could serve as a floor beneath the fed funds rate because banks should not be willing to lend reserves at a rate lower than what can be earned at the Fed. Yet the fed funds rate has consistently traded below the IOER since 2008 (Chart 4). The reason for this violation is that the IOER is only available to depository institutions with reserve accounts at the Fed. Other suppliers of short maturity funds, mostly the GSEs, are still willing to transact at lower rates (Chart 5). Chart 4In Need ##br##Of A Floor Chart 5Fed Funds Market Smaller, ##br## And Dominated By GSEs Chart 6Reverse Repo Facility Is New Floor On ##br##Rates Money Markets Under The Microscope A new facility is required, that is capable of absorbing all of the supply of overnight funds including that emanating from outside the traditional banking system. The Fed answered this requirement by creating a fixed rate overnight reverse repo (RRP) facility. Once fully implemented, the Fed will stand ready to borrow overnight in unlimited amounts, at a rate that it chooses (i.e. is set independently of market forces). By making this facility available to a larger set of counterparties than the IOER, including money market funds and the GSEs, the Fed now has a "hard floor" on rates that it will be able to use to raise interest rates when the time comes. Even though it is still in a testing phase, the RRP already appears to be acting as a floor for overnight rates (Chart 6). Bottom Line: The stockpile of excess reserves created by the Fed's large scale asset purchase program has made the federal funds market largely irrelevant. The Fed is now only able to implement monetary policy by placing a floor under short-term interest rates, the RRP. 3. Building On Higher Ground From an operational perspective, there are two possible ways forward for the Fed as it prepares to lift rates. One option would be to return to the pre-crisis method of operation described in the first section. To do this, the Fed would first have to drain all excess reserves from the banking system by either selling securities, or deploying some of the tools on the liability side of its balance sheet, such as term deposits.3 This would re-launch the federal funds market and the Fed could return to setting policy in its traditional manner, by targeting the fed funds rate. Unfortunately, there are simply too many excess reserves in the system to make this a viable strategy, at least for the next several years. Moreover, the pace of asset sales required to drain excess reserves in a timely manner would lead to large spikes in the Treasury term premium. Instead, the Fed will almost certainly choose to maintain large reserve balances and operate monetary policy by lifting the floor RRP rate. Specifically, the Fed will set the RRP rate equal to (or slightly below) the IOER. It will then hike rates by increasing both in tandem. The Fed may still choose to set a target for the fed funds rate at a level somewhat above the RRP to maintain consistency in its communications, but this rate will be meaningless. We outline the likely sequence of the Fed's exit strategy in the following Box. Box The Exit Strategy Revisited The Fed first articulated the likely sequence of the exit strategy in the minutes to the June 2011 FOMC meeting.4 That sequence was as follows: Cease reinvestment of principal on securities holdings. Modify forward guidance on the path of the federal funds rate, and initiate reserve draining operations (e.g. term deposits). Begin raising the target federal funds rate. Begin sales of securities holdings, with a goal of returning the balance sheet to a more traditional size within two to three years. The above sequence suggests the Fed was planning to first drain excess reserves and then conduct monetary policy operations in the fed funds market, as it did prior to QE. This strategy has now been abandoned, and we expect to receive a modified exit sequence before the end of the year. The revised sequence will be consistent with the implementation of policy using a floor system, with large excess reserves, and could look something like: Modify forward guidance on the path of interest rates (including IOER, RRP and fed funds). Begin raising interest rates. First by raising the RRP rate to slightly below the IOER, and then by raising both rates in tandem. A few months after rate hikes begin; cease reinvestment of principal on Agency and Agency MBS holdings. Much later; cease reinvestment of principal on Treasury securities. The Fed will probably cease reinvestment of its MBS holdings prior to its Treasury holdings, and will then let its MBS holdings run-off passively to zero. The Fed will also probably let some of its Treasury holdings run-off passively, but could decide to maintain a permanently larger balance sheet, depending on the success of the RRP and floor system. In the next few years, as its balance sheet begins to shrink through passive run-off, the Fed may decide to drain the remaining excess reserves and return to its traditional operating method as outlined in Section1 above. Either way, U.S. monetary policy will operate under a "floor system", using the RRP rate, for at least the next few years. This new method of operation comes with several potential drawbacks, which we address below. Excess Reserves Are "Dry Powder" For The Banking System Chart 7Drivers Of Bank Lending Many have speculated that banks have been choosing to sit on large excess reserve balances. The thinking is that eventually the economy will reach a turning point and banks will decide to convert their excess reserves to loans en masse, leading to a surge in bank lending, and eventually, inflation. This implies that the presence of large excess reserve balances would force the Fed to hike rates more quickly than in their absence. This concern stems from a misunderstanding of the money creation process described above. The Fed could fall "behind the curve" and normalize policy too slowly, which could ultimately lead to higher inflation. However, this would simply be a consequence of keeping interest rates too low for too long. The presence of excess reserves does not in itself create a desire to lend and thus poses no additional inflation risk. For one thing, the banking system in aggregate is powerless to reduce the amount of excess reserves without the Fed also taking action to reduce the supply. As shown in Figures 1 and 2, the supply of excess reserves is determined solely on the Fed's balance sheet. There is no danger of excess reserves "leaking out" into the economy. More importantly, however, is that the process of money creation begins with the origination of a loan and ends when the Fed increases the supply of reserves. The catalyst for the process, the amount of bank lending, is determined by (Chart 7): loan demand banks' perceived profitability from additional lending banks' concerns about taking too much risk on the balance sheet, putting their viability at risk regulatory requirements concerning capital and liquidity The Fed exerts control over these four factors through its interest rate policy, but not through changes in the balance of excess reserves. Prior to 2008, the lack of excess reserves did not act to constrain bank lending, rather the Fed chose to encourage or discourage lending by decreasing or increasing the interest rate. Similarly, the large excess reserve balances since 2008 have not provided an incentive to lend. Excess Reserves and Bank Regulation One implication of the Fed having sole control over the supply of bank reserves is that, through QE, it has effectively forced reserves onto bank balance sheets. These reserves obviously factor into banks' calculations concerning required regulatory ratios for liquidity and capital. Liquidity Coverage Ratio Chart 8Fed Purchases Pushed ##br##Term Premium Lower Under the proposed liquidity coverage ratio (LCR), banks must maintain a balance of high-quality liquid assets (such as bank reserves and Treasury securities) equal to their expected net cash requirement during a 30-day period. In theory, should the Fed ever decide to reduce the supply of excess reserves, banks could have trouble meeting the LCR requirement. In removing reserves, however, the Fed would also be selling securities. Banks falling short of their LCR requirement would be natural buyers for the securities offloaded by the Fed. Thus, the Fed's operating decisions will probably not exert any influence over banks' ability to meet their liquidity requirements. The LCR, however, does have implications for the equilibrium level of the Treasury term premium. Much as the Fed's Treasury purchases pressured the term premium lower (Chart 8), any future Treasury sales could be expected to unwind this effect. Even so, bank demand for those same Treasury securities would mitigate some of the upside for the term premium. Supplementary Leverage Ratio Large U.S. banks face a supplementary leverage ratio (SLR) which requires them to hold capital equal to at least 5% of total assets, not risk-weighted. In other words, large excess reserves force banks to hold more capital, which could have an adverse economic impact. Banks falling short of the SLR can either raise capital, or reduce assets. If they are either unable or unwilling to raise capital, then the large balance of excess reserves thrust upon them by the Fed could in theory crowd out bank lending. In other words, if the banking sector refuses to increase capital, then the onus falls on the asset side of the balance sheet to adjust to SLR standards. Since the banking sector in aggregate is unable to reduce reserve balances, any desired contraction in total assets could conceivably translate into an incentive to reduce the pace of bank lending. As currently proposed the SLR does not appear to be too big a hurdle for the largest U.S. banks. It is very likely they will be able to meet the requirement through retained earnings and new equity issuance. Nevertheless, it still provides a potential drag on bank lending that would not exist under the traditional model of monetary policy operations. Collateral Shortage Chart 9RRP Alleviates Collateral Shortage One side effect of the Fed's large scale asset purchases is that they have removed a lot of high-quality collateral from the financial system. Chart 9 shows that during periods when the Fed is adding to its balance sheet, the amount of collateral in the tri-party repo market declines. As the supply of collateral dwindles, repo rates are also pressured lower. The problem is that once repo rates approach the zero lower bound, counterparties have an increasing incentive to fail on delivery of repo contracts. Given the widespread use of repo financing, persistent repo fails have the potential to undermine liquidity in financial markets. Thankfully, the Fed's new tool for controlling the overnight interest rate, the RRP facility, solves this problem. In a reverse repo transaction, a counterparty purchases securities from the Fed with the understanding that it will sell them back the next day, earning the RRP rate in the process. This means the private sector once again gains access to collateral that had been cordoned off on the Fed's balance sheet. This should have the effect of keeping the repo rate above the floor set by the RRP, and well above zero. Repo fails have already levelled off and should begin to decline once the RRP facility is fully implemented. Financial Stability Concerns We have seen that monetary policy operates under a floor system when there are large reserve balances. One complication is that the U.S. is operating with two different floors, the IOER and the RRP. Due to its availability to a wider selection of counterparties, the RRP is the true floor on rates. From a monetary policy perspective, the easiest way forward is to set both rates at the same level and hike them in tandem. However, in a recent speech5 New York Fed President Dudley pointed out that from a financial stability perspective an RRP rate equal to the IOER could result in money flowing out of institutions eligible to receive IOER and into the less regulated shadow banking sector. It is therefore probable the Fed will choose to maintain the RRP at a level slightly below the IOER as rate hikes commence. We maintain focus on the RRP as the true floor on rates. President Dudley also made the case that the Fed's RRP facility could have positive implications for financial stability. He observed that with a Fed-backed short-term safe asset now more widely available, it could crowd out the creation of money-like liquid assets by the private sector. Those privately created liquid assets, such as commercial paper, are more prone to fire sales during times of stress. In a recent paper,6 John Cochrane agreed forcefully with this sentiment. Due to its potential for eliminating privately created money-like liquid assets, Cochrane referred to a monetary policy regime operating with large reserve balances as "a very desirable configuration of monetary affairs." The downside of the Fed providing a short-term safe asset is that it could encourage runs into the RRP during times of crisis. President Dudley rightly concludes that this is more of a technical hurdle that could be managed using caps on usage of the RRP facility. Bottom Line: The Fed will be able to operate monetary policy with large reserve balances, using the RRP as a floor on interest rates for several years while it decides by how much to run down its balance sheet and whether it should revert to its traditional fed funds rate target. Investors should remember that large reserve balances, by themselves, do not pose an inflation risk. Whether or not inflation becomes a problem will depend on the Fed's foresight to raise interest rates in a timely manner. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Alternatively it could be held in cash. This would be reflected on the banking sector's balance sheet as an increase in loans and a decrease in reserves, and on the Fed's balance sheet as an increase in currency in circulation and a decrease in reserves. 2 The Fed began paying interest on excess reserve balances on October 6, 2008. 3 The Fed's current Term Deposit Facility (TDF) temporarily drains reserves from the banking system by receiving funds from the banking sector for a period of 7 days, paying 26 basis points of interest. The early stages of the Fed exit strategy will rely more heavily on the overnight RRP facility rather than the TDF. But term deposits could be deployed once the Fed's balance sheet has returned closer to its traditional size, and the Fed decides it wants to drain the remaining excess reserves and return to its pre-crisis method of operation. 4 http://www.federalreserve.gov/monetarypolicy/files/fomcminutes20110622… 5 "The Economic Outlook and Implications for Monetary Policy" available at http://www.newyorkfed.org/newsevents/speeches/2014/dud140520.html 6 Cochrane, John H. Monetary Policy with Interest on Reserves. Available at http://media.hoover.org/sites/default/files/documents/2014CochraneMonet…

Highlights Despite our tactical bullish stance, the cyclical outlook remains firmly negative for the yen, with a 12-month target for USD/JPY above 120. The BoJ is currently committed to an inflation overshoot, with this solid commitment, a strong economy will be able to lift inflation expectations, depress real interest rates, and hurt the yen. The key improvements pointing to higher inflation expectations are: Already positive inflation expectation dynamics, the closing of the output gap, the removal of the fiscal drag, the tightness in the labor market, and the end of the private-sector deleveraging. The tactical environment suggests that nimble traders with short investment horizons should stay short USD/JPY for now. Longer-term investors may want to add to short bets on the yen on further weaknesses. Feature We have espoused a cyclically bearish stance on the yen since September when the BoJ began targeting the price of money instead of the quantity of money, aiming for stable JGB yields around 0%.1 More recently, we have been buyers of the yen on a tactical basis. Here, we are reviewing whether this tactical call should morph into a cyclical bullish stance on the yen or whether the primary trend for the yen still points lower. Ultimately, we expect USD/JPY to punch through 120 on a 12 month basis. The Liquidity Trap Our framework to analyze the yen rests on one key assumption: Japan remains mired in liquidity trap dynamics. As we have pointed out before, the key symptom of this disease is evident in the Land of the Rising Sun: Loan demand has become irresponsive to changes in private sector borrowing costs (Chart I-1). In this environment, we can experience strange dynamics. As we argued in details a few months ago, when both in a liquidity trap and at the lower bound of interest rates, the demand for money is infinite, and interest rates are independent of the level of output in the economy.2 In other words, a decrease in exports, government spending, or investment, hurts demand without affecting nominal interest rates (Chart I-2, middle panel). However, in the long run, decreases in aggregate demand exert downward pressure on prices, and thus, lower inflation expectations today (Chart I-2, bottom panel). The opposite is true for a positive demand shock. Chart I-1The Symptom Of Disease Chart I-2The Thing That Should Not Be In this topsy-turvy world, a negative shock to growth, by decreasing inflation expectations, pushes up real interest rates, and thus the exchange rate. Meanwhile, a positive shock increases inflation expectations, pulling down real rates and the exchange rate as well. This is fundamental as USD/JPY continues to trade closely in line with real rate differentials between the U.S. and Japan (Chart I-3). Chart I-3USD/JPY: No Money Illusion Here This is even truer now that the Bank of Japan is both trying to keep 10-year JGB yields near 0%, and has promised to keep a very accommodative monetary policy in place until inflation has overshoot the price stability target of an average inflation rate of 2% over the whole business cycle. In other words, the BoJ's inflation target is near symmetrical and monetary policy will only harden once previous inflation undershoots below 2% have been compensated by an extended period of inflation overshoot. Also, we expect the BoJ to stay committed to this policy. Not only does Abenomics remain popular in Japan, but we expect Kuroda to be re-appointed to lead the BoJ. Moreover, the last two members of the policy committee not appointed by Abe will see their terms end in 2017. After this year, the BoJ committee will fully represents Abe's wishes. Under this framework, the key to expect the yen to fall is therefore not valuation, nor the current account outlook - two factors pointing to a higher yen - but whether or not the economy and inflation expectations can improve durably on a cyclical basis. In the next section, we explore the key positive economic developments underpinning our negative JPY stance. Bottom Line: As the BoJ is strongly committed to maintaining an extremely dovish stance until inflation overshoots by a wide-enough margin to compensate for previous undershoots, key economic improvements in Japan should lead to higher inflation expectations, falling Japanese real interest rates, and a much weaker yen. The Five Samurais We see five reasons to remain bearish the JPY: Inflation expectation dynamics, the closing output gap, the disappearance of the fiscal drag, the labor market tightness, and the end of the Japanese private sector's deleveraging. Factor 1: Inflation Expectations Are Already Unhinged Even before the BoJ aggressively targeted 0% JGB yields, Japanese inflation expectations were on an improving path. During the 2012 summer, markets began correctly anticipating the December electoral victory of Shinzo Abe, apprehending that his BoJ was about to massively ramp up quantitative easing. Japanese 5-year/5-year forward CPI swaps soon decoupled from the rest of the world and the U.S. (Chart I-4). Chart I-4The BoJ Policy Has Already Borne Fruit Chart I-5The Mechanics Of Price-Level Targeting So strong has the perceived commitment of the BoJ to higher inflation been that Japanese inflation expectations never tanked the way U.S. ones did after 2014. These dynamics contributed to keep Japanese real rates depressed relative to U.S. ones. Moreover a virtuous circle was created where lower real rates supercharged the USD/JPY's rally, lifting it by more than 60% from 77 in September 2012 to 125 in June 2015, and this further supported Japanese inflation expectations. In the summer of 2015, as EM and commodity prices began imploding on the growing expectation of a Chinese economic hard landing, Japanese inflation expectations did relapse, strengthening the yen rally. But again, unlike in the U.S., Japanese CPI swaps never fell to new lows, pointing to some improving dynamics for the domestic component of Japanese inflation expectation formations. Going forward, we expect Japanese inflation expectations to move further up. The price level targeting mechanism put in place by the BoJ last fall reinforces inflationary dynamics (Chart I-5). Any anticipated tightening in monetary policy in response to economic improvements has been pushed further away in the future, in a world where inflation may be higher locally and globally. Additionally, if global and local inflation rises, because nominal interest rates are pegged at low levels, the increase in inflation expectations puts additional downward pressure on real rates, further stimulating the domestic economy, further weakening the yen, and further boosting inflation expectations. The circuits for positive feedback loops are being laid in place. Factor 2: The Output Gap Based on the OECD's estimates, the Japanese output gap has now moved into positive territory for the first time since 2007-2008, the last episode where Japan experienced anything close to inflation (Chart I-6). Prior to then, the last time the Japanese output gap was as positive as it will be in 2017 was in 1993, among the last years when Japanese core inflation was still above 1%. While this reflects the global phenomenon of low productivity growth, the low level of supply expansion in Japan has been augmented by the 2% decline in the labor force since 1998. This means that the capacity constraints in the Japanese economy are easy to reach even if average real GDP growth has only been 0.8% since 2010. The cyclical improvements in the business cycle only point toward an increasingly positive output gap and rising inflationary pressures. To begin with, business confidence and PMIs are all very robust (Chart I-7). Chart I-6No More Slack In Japan Chart I-7Japanese Businessmen Feel Good The strength of the U.S. ISM index suggests that Japanese exports have more upside (Chart I-8) as well. Not only does a stronger Japanese trade balance contributes to a larger positive output gap, but also, strong export growth has often been the key precursor to higher capex in Japan (Chart I-8, bottom panel). Finally, the credit dynamics remain supportive. Bank loan growth has not slowed much, despite the large tightening in Japanese monetary conditions in 2016. With conditions now easing in the country, we expect the credit impulse, which has bottomed around the zero line, to re-accelerate going forward, supporting excess demand above potential GDP growth (Chart I-9). Together, all these factors suggest that the improvement in the Japanese shipments-to-inventory ratio witnessed since March 2016 will continue to lift Japanese inflation expectations higher (Chart I-10). Chart I-8Strong Japanese Exports ##br##Will Filter To Capex Chart I-9The Japanese Credit ##br##Impulse Will Rebound Chart I-10Upward Momentum In ##br##Japanese Inflation Expectations Factor 3: Fiscal Policy Another key factor that has hampered the Japanese economy since 2013 has been the large fiscal belt-tightening experience by the country. In the wake of the 2011 Tohoku earthquake, the government primary deficit blew up to 7.7% of potential GDP in 2011. It will hit 3.5% for 2017, but the IMF does not forecast much more narrowing of the government budget gap (Chart I-11). This signifies that the great brake that slowed the Japanese economy and prevented a rise in inflation is being lifted. In fact, we expect the Japanese government deficit to increase again. First, Abe's upper house electoral victory last summer was built on a campaign of larger government spending. Second, with an approval rating of 56% four years into his premiership, Abe remains a highly popular prime minister for a country plagued by 15 changes of government since 1990. This is a vote of confidence by the Japanese public toward his "Abenomics" program. Finally, military spending is likely to increase. As recently as 2005, Japan's and China's defense budgets were the same; today, China outspends Japan by four times (Chart I-12). In an increasingly unstable Asia-Pacific region, where China, Russia, and North Korea are all conducting more independent foreign policy agendas, Japan will be forced to fend for itself with more military spending, underscoring the relatively hawkish agenda of the Abe administration on this front. This will require more spending by Tokyo in this arena. Chart I-11Vanishing Japanese##br## Fiscal Drag Chart I-12The Geopolitical Imperative To Increase ##br##Japanese Government Spending Factor 4: The tightening Labor Market The Japanese labor market has now become very tight and key supply-side adjustments are behind us. The job-openings-to-applicants ratio stands at July 1991 levels, the last time when Japan was able to generate any durable wage growth. Additionally, the level of participation of women in the labor force is very elevated. The employment-to-population ratio for prime-age females stands at 74%, well above the 71.4% level of the U.S. today, and just as high as the U.S. in 2000, when that ratio was at its highest (Chart I-13). Additionally, despite a shrinking labor force and population, the total number of employed individuals stands at 65 million, the highest level since 1999 (Chart I-14). Hiring growth is also experiencing its most vigorous upswing in 20 years. Unsurprisingly, nominal wages have been growing since 2013, the longest upswing since 2004 to 2006, and wages are now at their highest level since 2009 (Chart I-14, middle panel). Chart I-13The Japanese Labor Market Is Very Tight (I) Chart I-14The Japanese Labor Market Is Very Tight (II) With the economy remaining robust, the output gap being closed, and the fiscal drag disappearing, this tightening in the labor-market should lead to additional wage gains in Japan. As the labor market slack dissipates further, we expect Japanese employment growth to slow and wages to accelerate their upward path. It is true that the Japanese labor market duality still constitutes a structural damper on Japanese wages, but for now, the very important positive cyclical factors noted above should overpower this long-term negative. Only with additional reform of the labor market will this duality dissipate structurally. Factor 5: End Of The Private Sector Deleveraging The last factor that has turned the corner in Japan is the evolution of the private sector's deleveraging. Non-financial private debt fell from 220% of GDP in 1994 to 160% of GDP today, after having stabilized since 2009 (Chart I-15). At these levels, the Japanese non-financial private debt to GDP is in line with the worldwide average of 157%, much below China's 210%, as well as below the levels recorded in Canada, Australia, New Zealand or Sweden. This development is key for many reasons. First, since 2011, Japanese households have in fact re-levered, with their debt load rising by 6.5% since their trough. This means that Japanese households are generating demand in excess of their earnings, and are therefore a source of inflation in the country. Second, the end of deleveraging has coincided with an end to the decline in Japanese land prices that has put downward pressure on all prices since 1991 (Chart I-16). Finally, the rising debt load of the Japanese government is no longer just a compensating mechanism for the deficiency in demand created by the private sector's sector deleveraging. In fact, like for households, government dissaving is now purely adding to the aggregate demand of Japan, and at the margin, is inflationary. Unsurprisingly, since 2012, periods of accelerating growth in the Japanese broad money supply have now been associated with periods of weakness in the yen (Chart I-17). This highlights the fact that money creation is now generating some increase in inflation expectations as the private sector is not furiously building its savings anymore and as the Kuroda BoJ is not leaning against inflationary developments. Chart I-15Private Sector Deleveraging Is Over Chart I-16Land Prices Are Not A Source Of Deflation Anymore Chart I-17Money Matters Putting It All Together In our view, in an environment where Japan is beginning to generate domestic inflationary pressures of its own, where the output gap is now positive, where the government is not putting a brake on growth anymore, where the labor market is at its tightest in decades, and where private sector deleveraging is not an handicap anymore, any improvement in global growth is likely to result in further increases in Japanese inflation expectations. Our sister service, Global Investment Strategy is long Japanese CPI swaps, a trade we agree with. In the context of FX, with the BoJ firmly on an easing path, rising Japanese inflation expectations will only depress Japanese real rates, exactly as the Fed becomes more aggressive. As a result, on a 12-18 months basis, the downside for the yen is very large. What About Trump? Chart I-8Japan FDI Profile President Trump wants to see a lower dollar to achieve his goal of creating manufacturing jobs in the U.S. Much ink has been spilled on the potential emergence of a Plaza 2.0 accord. We disagree. The U.S. has very little leverage to boost the value of the yen. The Bank of Japan's policy is designed to generate domestic inflationary pressures, the yen is only a casualty of this policy. In fact, with inflation expectations having been so low for so long, no country in the world can better justify having a very loose monetary policy setting than Japan. Also, the 97% surge in the yen that followed the Plaza accord of 1985 caused Japanese interest rates to stay too low relative to the state of the economy. As a result, a massive debt bubble ensued that lifted the economy further, but then prompted the bust which Japan still pays for. Today, the Japanese are unlikely to want to repeat the same mistake. While we do think that deleveraging has ended in Japan, a country with a falling population is unlikely to begin a new private-sector debt supercycle either. Finally, China continues to be an economy that saves too much. This means that China can either allocate these savings domestically through the debt market or export them internationally through its current account surplus. We expect Chinese authorities, who are already very worried by the high debt load in China to choose the second option for the next two years. As a result, BCA foresees further declines in the RMB over the next 12 to 18 months. In this environment, the Japanese would find it very difficult to remain competitive in the Chinese market if their currency rises as the RMB weakens.3 That being said, Trump will want some concessions out of the Japanese. Already, the February 10 meeting between the U.S. president and PM Abe is giving us a glimpse of things to come. Japanese non-tariff barriers on U.S. products are likely to decrease, potentially in the agricultural and automotive field especially. Additionally, Japan still runs a large current account surplus and therefore, a large capital account deficit. We expect Japanese FDIs in the U.S. to only grow going forward. The main beneficiary is likely to be the automotive sector as it would be the key mechanism for Japanese firms to avoid paying large tariffs / punitive taxes and still access the vital U.S. market (Chart I-18). Moreover, this fits well within Trump's agenda as it creates manufacturing jobs in the U.S. Call it a win-win situation if you will. Not Time To Close Short USD/JPY Yet Despite this very negative cyclical view on the yen, we remain committed to our tactical short USD/JPY position: For one, positioning on the yen remains too extreme (Chart I-19). Second, as argued by our European Investment Strategy service, we may be on the cusp of a mini down cycle in the credit impulse, suggesting a temporary deceleration in the G10.4 The recent collapse in quarterly credit growth in the U.S. points exactly in this direction (Chart I-20). Because U.S. 10-year bond yields are so tightly linked to global economic surprises, negative surprises could put temporary downward pressure on Treasury yields (Chart I-21). A move lower in yields would be very supportive of the yen, even if only for a few months. Chart I-19Speculators Are Still Too ##br##Short JPY Tactically Chart I-20Falling Short-Term Credit##br## Impulse In The U.S. Chart I-21Falling Surprises Can##br## Temporarily Help Bond Prices Third, the dollar correction is not over. Sentiment and positioning on the dollar represent tactical hurdles that need to be overcome before the greenback can resume its ascent. Also French OAT / German bunds spreads are at distressed levels, having only been higher at the height of the euro crisis in 2012, and not far off the levels experienced during the ERM crisis of the early 1990s (Chart I-22). This suggests that the risk of a Le Pen presidency is now well known. We agree that the impact of such an event would be enormous, but the 34.5% odds currently assigned to it on Oddschecker are too great, especially now that Bayrou - a centrist politician - is not entering the race and putting his support behind Macron. Finally, the dollar has followed a textbook wave pattern since October. A continuation of this pattern suggests that the DXY has downside toward 97-98 (Chart I-23). Chart I-22OAT / Bund Spreads Price In A Lot Of Negatives Chart I-23A Textbook Wave Pattern In The Dollar The ultimate factor in favor of the continuation of the yen correction is the higher degree of complacency that has settled globally. Our Global Complacency indicator, based on the G10 stock-to-bond ratio, commodity prices, and the VIX is at an extremely elevated level warning of a potential risk-off event globally. Any rollover in this very mean-reverting indicator would prompt a further weakness in USD/JPY as well as AUD/JPY, especially if the BoJ doesn't increase stimulus in the meantime (Chart I-24). Chart I-24AUnless The BoJ Eases Further, Too Much ##br##Complacency Equals Tactically Long JPY Chart I-24BUnless The BoJ Eases Further, Too Much ##br##Complacency Equals Tactically Long JPY Bottom Line: Tactical investors should continue shorting USD/JPY for the moment. More cyclical players can begin deploying capital to short the yen as the cyclical outlook for this currency remains dire, but better opportunity to sell this currency are likely to emerge over the coming months. A dollar-cost averaging strategy seems wise at this point. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see the Foreign Exchange Strategy Weekly Report, "How do You Say "Whatever It Takes" In Japanese?", dated September 23, 2016, available at fes.bcaresearch.com 2 Please see the Foreign Exchange Strategy Weekly Report, "Down The Rabbit Hole", dated April 15, 2016, available at fes.bcaresearch.com 3 For a more detailed discussion on the RMB, please see the Global Investment Strategy Weekly Report, "Does China Have A Debt Problem Or A Savings Problem?", dated February 24, 2017, available at gis.bcaresearch.com 4 For a more detailed discussion of the mini-cycle, please see the European Investment Strategy Weekly Report, "Slowdown: How And When?", dated February 2, 2017, available at eis.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The U.S. economy is giving a green light to the Fed to hike. Headline CPI is at 2.5% annually, and core CPI is at 2.3%; Retail sales beat expectations at 0.4% MoM; The core CPI measure is evidence that the U.S. economy is fundamentally strong and dynamic. Real GDP now stands 11% above its pre-recession peak, and it is approaching the Congressional Budget Office's estimate of potential output. The unemployment and output gap are also close to their long-term levels. With the economy closing in on its potential, it is only natural that FOMC participants "expressed the view that it might be appropriate to raise the federal funds rate again fairly soon" in the Minutes. Although a risk of disappointment from Trump's fiscal proposal is possible, the economy's momentum will continue. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Risks To The Cyclical Dollar View - February 3, 2017 Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism - January 27, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 The euro area remains robust, with this week's data showing a strong outperformance: German, French and overall euro area PMI increased and beat expectations across all measures, with the exception of France which only outperformed on the Composite measure; Euro area producer prices strengthened to a 2.4% annual pace; After seeing some downside from worries about a Le Pen victory, markets have calmed François Bayrou, a centrist, announced an alliance with presidential candidate Emmanual Macron, adding a resistance to the euro's downside. Substantial volatility can still be expected, however, as a Le Pen victory is not completely out of the realm of possibility, which means that the euro can see some weakness in the near term. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 The French Revolution - February 3, 2017 GBP: Dismal Expectations - January 13, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Positive signs continue to emerge in Japanese data: Industrial production yearly growth came in at 3.2% Nikkei Manufacturing PMI came in at 53.5, outperforming expectations Japan's Leading Economic Index came at 104.8, the highest level since 2015 These economic developments are good news for the BoJ, as it shows them that their price level targeting and yield curve control measures seem to be working. However the objective of these measures is not to achieve these marginal improvements in the economy. The objective is to catapult Japan out of the liquidity trap it is in, which means that these measures will likely stay in place for a while. Therefore, on a cyclical basis we remain short the yen, as we expect USD/JPY to reach 120 on a 12 to 18 month horizon. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism - January 27, 2017 Update On A Tumultuous Year - January 6, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data has painted a mixed picture for the U.K. Industrial and manufacturing production yearly growth came in at 4.3% and 4% respectively. Both measures blew past expectations. Also, in spite of the dramatic fall in the pound, Inflation seems to be relatively contained, as both core and headline numbers came in below expectation at 1.8% and 1.6% respectively. However not everything is good news. Yearly growth for retail sales and retail sales ex fuel underperformed expectations coming at 1.5% and 2.6%, respectively. Additionally, wage growth has been limited, as average weekly earnings yearly growth came below expectations at 2.6%. We continue to be bullish on the pound, particularly against the euro as any additional political risks caused by Brexit are now well known by participants, making the pound very cheap, especially if one takes into account real rate differentials. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The AUD has been the top performing currency against the USD out of the G10, having appreciated 7.11% since the beginning of the year. This rally is increasingly tenuous. Full-time employment has struggled to pick up, while part-time employment increased by 4%. This will hamper wage growth and consumption going forward. This is important as consumption is already 58% of the economy. Meanwhile, net exports have made a negative contribution to GDP growth for almost two years. In fact, Australian exports to China subtracted 1% of GDP growth last year, due to a decline in commodity prices. Going forward, a limited upside in commodity prices and an end to the Chinese easing cycle can exacerbate this decline. On a technical basis, AUD/USD has sustained momentum since the beginning of the year, with the RSI displaying overbought levels since mid-January. The cross is also approaching a key resistance level, pointing to growing risks ahead. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Risks To The Cyclical Dollar View - February 3, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data for New Zealand has not been particularly positive and have weighed on the kiwi: Retail sales underperformed, growing by 0.8% QoQ against expectations of 1.1%. Business NZ PMI fell to 51.6 from last month's 54.5. Nevertheless, a closer look at the data paints a much brighter picture: the decline in NZ PMI seems to have been primarily due to bad weather conditions, which means that the strong fundamentals of the kiwi economy should show up in the data once seasonal factors start to dissipate. Therefore, we are bullish on the NZD versus the AUD, as the structural backdrop for these countries could not be further apart, yet the market is now pricing less than a 10 basis points difference from here until the end of the year. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Risks To The Cyclical Dollar View - February 3, 2017 Outlook: 2017's Greatest Hits -December 16, 2016 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Canadian employment numbers came out seemingly strong, with a net change in employment of 48,300 and a decrease in the unemployment rate to 6.8%. However, these numbers mask numerous underlying inconsistencies. The decrease in unemployment was the result of a robust part-time employment growth of 5.6%, not the 0.3% growth in full-time employment. Wage growth remains subdued, with average hourly earnings of permanent workers currently increasing at a 1% annual pace, compared to 3.3% a year ago. Furthermore, hours worked have declined by 0.8%, exacerbating the weakness of full-time employment's contribution to activity. Retail sales underperformed expectations, contracting at a 0.5% monthly pace; the measure excluding Autos also contracted at a 0.3% pace. Increasing household debt and festering labor market complications are likely to weigh on consumer confidence. An uncertain outlook on trade developments is an additional handicap to future CAD strength. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 During the last couple of weeks, fear of a Eurosceptick government in Europe's second biggest economy, has lowered EUR/CHF below the implied floor that the SNB has had for the last couple of years. Indeed, last week, as La Pen surged on French presidential polls, this crossed reached 1.063, its lowest level since August 2015. This is bad news for Switzerland, as economic data continues to indicate that the country has not been able to shake off the shackles of deflation: Headline inflation outperformed expectations as it finally exited deflationary territory, coming in at 0%. Industrial production contracted by 3.3% on a year on year basis Given this deflationary backdrop, the SNB will continue to try to limit the downside for this cross. However, on the months leading to the French elections, the floor will continue to get tested. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Inflation seems to be abating in Norway as core and headline inflation numbers fell sharply from last month reading, coming in at 2.1% and 2.8% respectively. This is the result of various factors: First, the inflation caused by the collapse of the krone is starting to fade away. From 2014 to 2016, the krone collapsed along with oil prices. This selloff in the krone passed through inflation to the Norwegian economy via rising imported goods, with a lag. Today, roughly one year after the NOK bottomed, the effects of the currency on inflation is starting to dissipate. Furthermore, labor market dynamics in Norway are anything but inflationary as wage growth is contracting by 4% and although unemployment is low, the Norges Bank has pointed out that is in largely caused by a fall in the participation rate. Thus, given that high inflation is receding, the Norges Bank will keep its easing bias for the time being. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits -December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The February 2017 Monetary Policy Statement illustrated a clear dovish stance. Governors and economists at the Riksbank are paranoid about risks emanating from a strong currency and political developments. Tensions from a recently strong SEK have created worries about a potential slowdown in inflation. The Bank has therefore reiterated the possibility of an intervention if the Krona's appreciation is too rapid, making it a very real possibility. A questionable political outlook from the U.S. and the euro area has further hampered the Riksbank's optimism. The euro area is a particular risk since it represents a large source of Sweden's growth, and any damage to the monetary union will have a catastrophic effect on Sweden. Because of these reasons, the Riksbank explicitly stated that it is "still prepared to make monetary policy more expansionary if the upward trend in inflation were to be threatened and confidence in the inflation target weakened." Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

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

Highlights Monetary Policy: Investors should fade the recent increase in expectations of a March rate hike. Still-low inflation and elevated policy uncertainty will keep the Fed on hold until June. Continue to position for a bear-steepening of the Treasury curve, driven by the combination of above-trend growth and accommodative Fed policy. Economy: U.S. growth will be higher this year than in 2016, driven mainly by rebounds in residential and non-residential investment. Consumer spending should also remain firm, driven by solid income growth and a savings rate that has scope to decline in the coming months. High-Yield: High-Yield valuations are tight, but still consistent with small positive excess returns to corporate credit during the next twelve months. Feature Chat 1A Hawkish Market Reaction After having been relatively subdued in the two months since the Fed's last rate increase, rate hike expectations priced into money market curves awakened last week following Janet Yellen's semi-annual Congressional testimony. Expectations priced into the overnight index swap curve have returned close to levels last seen on the day of the December 2016 FOMC meeting (Chart 1). As of last Friday's close, the market was priced for 53 basis points of rate increases between now and the end of the year, with a 26% chance that the next rate hike occurs in March. The implied probability of a March hike peaked at 34% last Wednesday.1 In this week's report we discuss why a March rate hike is unlikely. We also consider the outlook for U.S. economic growth in 2017, which we expect will remain decidedly above trend. Above-trend growth will allow the gradual increase in core inflation to persist, reaching the Fed's target by the end of the year. As a result, the Treasury curve will bear-steepen during this timeframe. To position for this outcome, investors should maintain below-benchmark duration and favor the belly (5-year bullet) of the curve relative to the wings (2/10 barbell) in duration-matched terms.2 Yellen's Hawkish Turn? Most news reports of Janet Yellen's testimony last week perceived a hawkish tone in her remarks and focused specifically on the following sentence: As I noted on previous occasions, waiting too long to remove accommodation would be unwise, potentially requiring the FOMC to eventually raise rates rapidly, which could risk disrupting financial markets and pushing the economy into recession.3 However, more important than the above boilerplate is the simple fact that inflation remains below target and the Fed has an incentive to tread cautiously to support its eventual recovery. There is no pressing need to move quickly on rate hikes and we expect that the next rate increase will not occur until June. One reason is that, in the current cycle, the Fed has not lifted rates without having first guided market expectations in the months leading up to the hike. As can be seen in Chart 2, rate hike probabilities implied by fed funds futures were already well above 50% one month prior to each of the last two rate hikes. If there was a strong desire to lift rates in March, Yellen would have likely sent a more powerfully hawkish signal in her testimony last week. Instead, Yellen chose not to mention the March meeting specifically and said only that the Fed would continue to evaluate the case for further rate hikes at its upcoming "meetings". Chart 2Market-Implied Rate Hike Probabilities: March Looks Too High Second, as was alluded to above, core PCE inflation is running at 1.7% year-over-year, still below the Fed's 2% target. What's more, long-dated TIPS breakeven inflation rates are also below levels that are consistent with inflation being anchored near the Fed's target (Chart 3). At present, the 5-year/5-year forward TIPS breakeven rate is 2.17%. Historically, a range of 2.4% to 2.5% is consistent with inflation at the Fed's target. Further, even though a strong January core CPI print, released last week, seemed to strengthen the case for a March hike, the details of the report show that only a few components (new cars +0.9% m/m, apparel +1.4% m/m, and airline fares +2.0% m/m) accounted for most of the gains. In fact, our CPI diffusion index fell even further below the zero line. With both our CPI and PCE diffusion indexes in contractionary territory (Chart 4), it is very likely that inflation will soften in the coming months. Chart 3Inflation Still Too Low Chart 4Inflation Recovery Not Broad Based Both our own and the Fed's forecasts for continued inflation increases are contingent on the view that tight labor markets are causing wage pressures to mount, and certainly wages have accelerated during the past few years. However, wage growth in both real and nominal terms is still below where the Fed would like it to be, and there has been scant evidence of wage acceleration during the past few months. While the Atlanta Fed's Wage Growth Tracker remains strong in nominal terms, it has leveled off in real terms, and both the Employment Cost Index and Average Hourly Earnings have recently been flat (Chart 5). A final factor that will prevent the Fed from lifting rates in March is the extremely high degree of policy uncertainty. As shown in Chart 6, economic policy uncertainty traditionally correlates with financial conditions. With financial markets having already discounted a very positive fiscal policy outcome, there is a heightened risk that some disappointing news on the fiscal front will lead to a sharp tightening of financial conditions in the near term. Such an event would definitely put the Fed on hold until financial markets recovered. Chart 5Fed Needs Wage Growth To Pick Up Chart 6Policy Uncertainty Remains Elevated Bottom Line: Investors should fade the recent increase in expectations of a March rate hike. Still-low inflation and elevated policy uncertainty will keep the Fed on hold until June. Continue to position for a bear-steepening of the Treasury curve, driven by the combination of above-trend growth and accommodative Fed policy. Policy Aside, U.S. Growth Is Heating Up Chart 7ISM Surveys Point To Strong Growth Most recent economic discussion has focused on when President Trump will get around to enacting some of the more stimulative parts of his policy agenda, and whether or not the impact of these policies (tax cuts, infrastructure spending) will ultimately be offset by other spending cuts. But in the meantime, leading indicators of GDP growth have been picking up steam. Both the manufacturing and non-manufacturing ISM surveys point to an increase in GDP growth in the first quarter (Chart 7), and consistently, the New York Fed's tracking model suggests Q1 GDP will grow by 3.1%. The Atlanta Fed's GDP tracking model pegs Q1 growth slightly lower at 2.4%. Our own sense is that GDP growth will remain solidly above trend this year, in the range of 2.5% to 3%, even in the absence of major fiscal stimulus. This forecast hinges on the view that both residential and non-residential investment will rebound from the depressed levels seen last year and that consumer spending will remain strong. Residential Investment Chart 8Residential & Non-Residential Investment Residential investment was actually a drag on GDP growth for two quarters in 2016, even though leading indicators such as the months supply of new homes and homebuilder confidence remained supportive (Chart 8, panels 1 & 2). The progress made on foreclosures since the financial crisis has driven housing inventory to its lowest level since the mid-1990s,4 meaning that housing supply no longer poses a headwind to construction. Further, demographics should also help boost the housing market during the next few years. According to the Joint Center for Housing Studies of Harvard University, over the next ten years, the aging of the Millennial generation will boost the population in their 30s. The growth in this age cohort implies an increase of 2 million new households each year on average.5 While rising mortgage rates will be a drag on housing at the margin, they will not pose a significant headwind to residential investment in 2017. At least so far, mortgage purchase applications have been resilient in the face of rising rates (Chart 8, panel 3). Non-Residential Investment Non-residential investment was a small drag on growth in 2016, but this was largely related to depressed investment in the energy sector (Chart 8, panel 4). Now that the oil price has recovered, non-residential investment should return to being a small positive contributor to growth. Our composite indicator of New Orders surveys also suggests that non-residential investment will trend higher this year (Chart 8, bottom panel). While there is some concern that the optimism displayed in these survey measures may not filter through to the "hard" economic data, a Special Report from our Bank Credit Analyst publication that will be published on Thursday concludes that a tangible growth acceleration is indeed underway throughout the G7. Consumer Spending As always, the consumer is the main driver of U.S. growth and we expect consumer spending will remain firm in 2017. Our U.S. Investment Strategy service recently undertook a detailed analysis of consumer spending,6 focusing on its two main drivers - income growth and the savings rate (Chart 9). A look at past cycles suggests that income growth can remain strong even after the economy reaches full employment as rising wages compensate for decelerating payroll growth (Chart 10). The recent spike in consumer income expectations suggests that the impact from rising wages might be particularly important in the current cycle (Chart 10, panel 1). Chart 9Consumer Spending Is Driven By Income Growth And The Savings Rate Chart 10Wages Can Drive Income Growth Another benefit of the economy reaching full employment is that increased job security can translate into greater consumer confidence and a lower savings rate (Chart 9, bottom panel). Confidence trends suggest that the savings rate has scope to decline during the next few months. One possible headwind to consumer spending is the recent tightening of consumer lending standards. The Fed's Senior Loan Officer Survey for the fourth quarter of 2016 shows that lending standards on auto loans have tightened for three consecutive quarters and that credit card lending standards also recently spiked into "net tightening" territory. In other words, more banks are now tightening lending standards on consumer loans than easing them. Prior to the financial crisis, consumer lending standards were strongly correlated with the savings rate (Chart 11). More stringent lending standards slowed the pace of consumer credit growth and led to reduced consumer spending. But this relationship broke down following the financial crisis. After the housing bust, households were no longer eager to supplement their consumption with as much credit as possible. Their chief concern became repairing their own balance sheets. As such, the supply of credit is no longer the most important driver of the savings rate. In the data, we observe that the savings rate did not fall by as much as would have been predicted by easing lending standards in the early years of the recovery. As a result, we do not think that modestly tighter lending standards will have much of an impact either. The Fed's latest Senior Loan Officer Survey also showed that demand for consumer credit declined sharply in 2016 Q4. This is potentially more worrisome for the savings rate since lower credit demand may still suggest a reduced appetite for spending, even in the wake of the Great Recession. However, a look back at prior cycles shows that loan demand from the Senior Loan Officer Survey tends to decline several years prior to the next recession, but the savings rate has tended to stay low until the next recession actually hits (Chart 11, bottom panel). We would not be surprised to see the same dynamic play out again. Bottom Line: U.S. growth will be higher this year than in 2016, driven mainly by rebounds in residential and non-residential investment. Consumer spending should also remain firm, driven by solid income growth and a savings rate that has scope to decline in the coming months. Chart 11Lending Standards Less Of A Risk Chart 12Default-Adjusted Spread A High-Yield Valuation Update With the release of the Moody's default report for January we are able to update our forecast for High-Yield default losses during the next 12 months, and also our High-Yield default-adjusted spread. The default-adjusted spread is our preferred valuation indicator for both High-Yield and Investment Grade corporate bonds. It is calculated by taking the option-adjusted spread from the Bloomberg Barclays High-Yield index and subtracting an estimate of expected default losses during the next twelve months (Chart 12). Default loss expectations are calculated using the Moody's baseline forecast for the 12-month High-Yield default rate and our own forecast of the recovery rate based on its historical relationship with the default rate (Chart 12, bottom two panels). The current reading from our default-adjusted spread is 152 basis points. Most of the time, a reading of 152 bps on the default-adjusted spread is consistent with small positive excess returns for both High-Yield and Investment Grade corporate bonds (Chart 13 & Chart 14). This is also consistent with the excess returns we expect from corporate credit this year. Chart 1312-Month Excess High-Yield Returns Vs. Ex-Ante ##br##Default-Adjusted Spread (2002 - Present) Chart 1412-Month Excess Investment Grade Returns Vs. Ex-Ante High-Yield##br## Default-Adjusted Spread (2002 - Present) In fact, when the default-adjusted spread is between 150 bps and 200 bps, 12-month excess returns to High-Yield have been positive in 65% of cases, with a 90% confidence interval placing 12-month excess returns in a range between -5.0% and +1.7%. Given the favorable economic back-drop of strong economic growth and accommodative Fed policy, we would expect High-Yield excess returns to be positive during the next 12 months. But given the tight starting valuation, probably not above +1.7%. Bottom Line: High-Yield valuations are tight, but still consistent with small positive excess returns to corporate credit during the next twelve months. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Our internal calculations of rate hike probabilities implied by fed funds futures are lower than those shown on Bloomberg terminals. Our measure differs because we use the actual data for the effective fed funds rate and also adjust for the well-known fact that the effective fed funds rate tends to fall by approximately 10 basis points on the last day of the month. 2 For further details on our recommended yield curve trade please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 3 https://www.federalreserve.gov/newsevents/testimony/yellen20170214a.htm 4 Please see U.S. Bond Strategy Weekly Report, "Inflation: More Fire Than Ice, But Don't Sound The Alarm", dated January 24, 2017, available at usbs.bcaresearch.com 5 Please see "The State Of The Nation's Housing 2016", Joint Center for Housing Studies of Harvard University. 6 Please see U.S. Investment Strategy Weekly Report, "U.S. Consumer: The Comeback Kid", dated January 16, 2017, available at usis.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Special Report

Highlights Duration: Growth, inflation & investor risk-seeking behavior remain bond-bearish in both the U.S. & the Euro Area. Market technicals, both in terms of oversold momentum and heavy short positioning, are the biggest headwind to higher yields in the near-term. USTs vs. Bunds: U.S. Treasury yields will remain under upward pressure from a hawkish Fed with the U.S. economy operating at full employment. The opposite is true in Europe, at least until Euro Area inflation is much higher. Stay overweight core Europe versus the U.S. in global hedged bond portfolios Feature Chart of the WeekCan The Bond Selloff Continue? Last week brought the first serious test of the bond bear phase that has been in place since last July. The 10-year U.S. Treasury yield dipped as low as 2.33% after a benign January U.S. Payrolls report that substantially reduced the odds of a March Fed rate hike. German Bund yields also dipped as renewed worries about the upcoming French election triggered a flight to quality out of French and Peripheral sovereign debt. Even the chartists got in on the act, talking of an imminent breakdown below the "head & shoulders neckline" on the 10-year U.S. Treasury that would herald a 25bp decline in yields. Adding to the growing sense of nervousness among investors is a fear that the "Trumpflation" trade could soon run out of gas, with a correction of both elevated equity prices and bond yields likely in the absence of concrete economic news from the White House. Yet all it took was for Trump to simply mention that a "phenomenal" announcement on his tax plan was coming in the next few weeks to restart the Trump trades, pushing equity indices to new highs and driving up bond yields. Given all the conflicting forces at play in developed bond markets - accelerating growth, rising inflation, fiscal and political uncertainties, bearish bond investor positioning - we believe it is important to stay grounded by focusing only on the most relevant factors while trying to sift out the signal from the noise. This week, we are introducing a new "Duration Checklist" for both U.S. Treasuries and German Bunds, highlighting the key economic and market indicators that we are watching to assess whether we should maintain our current below-benchmark portfolio duration stance. From this checklist, we can confirm that the bond-bearish backdrop remains intact, with more indicators pointing to higher yields in the U.S. relative to core Europe. Describing The Elements Of Our Checklist The individual components of bond yields that we typically monitor - term premia, inflation expectations and shifts in the market-implied path of policy rates - have all contributed to the rise in U.S. and European bond yields since last July (Chart of the Week). Some of the factors that have driven yields higher are global in nature, like faster economic growth and rising energy prices, while others are more country-specific, like rising wage inflation in the U.S. To account for those different factors, we need to include a variety of indicators in our new GFIS Duration Checklist. The goal of list is to answer the specific question: "what should we watch to maintain a below-benchmark duration stance in the U.S. and core Europe?" The items in the Checklist are shown in Table 1, broken down into the following groupings: Table 1Stay Bearish On Treasuries & Bunds Accelerating Global Growth: Here, we are looking at indicators that are pointing to a quickening pace of global economic growth that would put upward pressure on all developed market bond yields. Specifically, we are looking to see if: a) the annual growth in the global leading economic indicator (LEI) is accelerating; b) our diffusion index for the global LEI is above 50 (suggesting a majority of countries with an expanding LEI) and rising; c) the global ZEW economic sentiment index is increasing; d) the global data surprise index is moving higher; and e) our measure of the global credit impulse (the 6-month change in credit growth among the major economies, one of BCA's favorite leading economic signals) is expanding. These global indicators are all shown in Chart 2. The global LEI growth rate, the global ZEW index and global data surprises are all moving higher, consistent with upward pressure on bond yields, and thus warrant a "check" in our GFIS Duration Checklist. The LEI diffusion index is well above 50, but has hooked down slightly in the past few months, as has the global credit impulse. These moves are relatively modest, and it is not yet certain whether they represent a change in trend in these series. For now, we are giving these indicators a "check", but with a question mark attached. If we see additional declines in the diffusion index and the global credit impulse in the next few months, we would interpret that as a sign that the cyclical global upturn is in danger of losing momentum, thus reducing the upward pressure on bond yields. Accelerating Domestic Growth: These are economic data that are specific to each country that would be consistent with higher yields; a) manufacturing purchasing managers' indices (PMIs) that are above 50 and rising; b) expanding consumer confidence; c) rising business confidence; d) faster growth in corporate profits. The relevant data for the U.S. are shown in Chart 3, which shows that all elements are increasing in a fashion that is bearish for U.S. Treasuries. The popular perception is that the recent surge in business confidence (both for corporate CEOs and small business owners) is simply a "Trump effect" from the new president's pro-business economic platform. However, the acceleration in corporate profit growth, which our own models are suggesting will continue in the coming quarters, is a sign that there is a more fundamental reason for firms to feel more optimistic. Chart 2Global Growth Still Pointing To Higher Yields Chart 3U.S. Domestic Upturn Is Solid We give all the U.S. domestic growth indicators a "check" pointing to a need to stay below-benchmark U.S. duration. The specific Euro Area growth data is shown in Chart 4. Similar to the U.S., all the indicators are moving higher in a bond-bearish direction, warranting a "check" on the Euro Area Duration Checklist. The political tensions stemming from the busy election calendar in Europe this year represent a potential negative shock to confidence. As we discussed in our Special Report published last week, however, we do not foresee a populist election shock in France akin to Brexit or Trump that would derail the Euro Area economic expansion.1 Rising Domestic Inflation Pressures: These are data that are specific to each country that would be consistent with faster inflation and higher yields: a) the annual growth in the oil price, in local currency terms, is accelerating; b) wage inflation is rising; c) the unemployment gap (the difference between the unemployment rate and the full employment NAIRU rate) is closed or nearly closed; The U.S. inflation data is shown in Chart 5, with all the indicators warranting a bond-bearish "check" in our U.S. Duration Checklist. The rising trend in oil prices continues to put upward pressure on headline U.S. inflation, even with the strong U.S. dollar. Meanwhile, the unemployment gap is now closed and U.S. wage inflation is grinding higher. This should be consistent with additional modest gains in core inflation that will put upward pressure on the inflation expectations component of U.S. Treasury yields (bottom panel). Chart 4Euro Area Domestic Upturn Is Solid Chart 5U.S. Inflation Trends Still Bearish For USTs It is a different story in the Euro Area, as can be seen in Chart 6. While the rapid acceleration in the Euro-denominated price of oil is starting to feed through into faster headline inflation, there still exists a positive unemployment gap that is helping keep wage growth, and core inflation, muted. A continuation of the recent economic upturn will likely put more downward pressure on Euro Area unemployment, but, for now, only the oil price acceleration justifies a "check" in the Euro Area Duration Checklist. Chart 6Euro Area Inflation Is A Mixed Bag Central Bank Policy Stance: Here, we are not including any charts, but are only stating whether the central bank has a bias to tighten monetary policy. That is certainly the case in the U.S., where the Fed has already delivered a 25bp hike in December and continues to signal that up to three more hikes will occur in 2017 if the FOMC growth forecasts are realized. So we put a "check" in this box on the U.S. side of the checklist. The European Central Bank (ECB) continues to maintain an unusually accommodative monetary stance, using a combination of asset purchases, negative policy rates and dovish forward guidance. We continue to see a potential shift away from this super-easy policy bias in the latter half of the year - in response to the upturn in economic growth and acceleration of Euro Area inflation towards the ECB's 2% target - as the biggest risk for both Euro Area bonds, in particular, and global bonds, in general. For now, however, the ECB is signaling no imminent shift to a more hawkish stance, so we are placing an "x" in the central bank portion of the Euro Area checklist. Risk-Seeking Behavior In Financial Markets: Here, we are checking to see if pro-growth, pro-risk asset classes are outperforming and whether market volatilities are rising. Risk asset outperformance and stable vol suggests that investors are less interested in risk-free government bonds: a) the domestic equity index is rising but is not yet 10% above the 200-day moving average (a level that has coincided with post-crisis equity market and bond yield peaks); b) domestic corporate bond spreads are either flat or falling rapidly; c) domestic equity market volatility is low and falling rapidly. The U.S. indicators are shown in Chart 7, while the Euro Area data is shown in Chart 8. The story is the same in both regions, with equity markets in a bullish trend but not yet at a fully-stretched extreme, credit spreads (both for Investment Grade and High-Yield) tight, and equity market volatility at multi-year lows. We view these indicators as signs that investors are less interested in owning U.S. Treasuries and German Bunds than owning equities and corporate debt. This will help bond yields drift higher on the margin as economic growth and inflation rise in the coming months. Thus, we place a "check" on all three elements in both the U.S. and Euro Area Duration Checklists. Chart 7Risk-Seeking Behavior In The U.S. Chart 8Risk-Seeking Behavior In Europe Contrarians may look at those same charts and say that this is more of a sign that investors are too optimistic and are now exposed to any negative growth shock, potentially representing a trigger for a selloff of risk assets and a move into government debt. We prefer to view the bullish performance of growth-sensitive assets as a sign of underlying investor risk appetite. Domestic Bond Market Technicals: Here, we are simply looking at measures of price momentum and market positioning in government bonds, to assess if there is room for additional yield increases as investors reduce exposure: a) the domestic 10-year bond yield is not stretched to the upside versus the 200-day moving average; b) the domestic Treasury index total return momentum (26-week rate of change) is not stretched to the downside; c) bond investor positioning is not already short. The 10-year U.S. Treasury technicals are shown in Chart 9, while the German Bund technicals are shown in Chart 10. The story is quite simple here - the rapid run-up in global bond yields late last year has led to stretched, oversold conditions on both sides of the Atlantic. Sentiment remains bearish in U.S. Treasuries, with massive net shorts in bond futures, suggesting that an overhang of positions remains a major headwind to higher yields. While we do not have positioning data for Euro Area bond investors, the momentum charts for German Bunds look very similar to the U.S. Treasury charts. Clearly, we must place an "x" in all these boxes on both Duration Checklists. Chart 9Stretched Technicals In U.S. Treasuries... Chart 10...And In German Bunds So What Are The Checklists Telling Us? Adding it all up, and the vast majority of the indicators in both checklists are pointing to continued upward pressure on bond yields, justifying a below-benchmark duration stance. The lack of core inflation pressure in the Euro Area, however, suggests that there is less upward pressure on German Bund yields relative to U.S. Treasuries, thus we continue to recommend an overweight stance on Bunds versus Treasuries in global hedged bond portfolios. Oversold conditions suggest that yields will have a tough time rising quickly from here while the market continues to consolidate the late 2016 bond selloff. However, a major bond market reversal is unlikely given the solid upturn in global growth. Bottom Line: Growth, inflation & investor risk-seeking behavior remain bond-bearish in both the U.S. & the Euro Area. Market technicals, both in terms of oversold momentum and heavy short positioning, are the biggest headwind to higher yields in the near-term. Maintain a below-benchmark portfolio duration stance in the near term, favoring German Bunds over U.S. Treasuries. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Special Report, "Our View On French Government Bonds", dated February 7, 2016, available at gfis.bcaresearch.com The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Rate Volatility: Forecast disagreement about GDP growth and T-bill rates will increase over the course of the year. This, alongside elevated policy uncertainty, will translate into higher interest rate volatility. Treasury Yields: Higher rate volatility should cause the term premium in the Treasury curve to increase at the margin. However, this impact could be offset if rate volatility and equity volatility rise in concert. An increase in equity vol would encourage flight-to-safety flows into bonds. MBS: Higher interest rate volatility and the unwinding of the Fed's mortgage portfolio will lead to wider MBS spreads during the next two years. Feature Low interest rate volatility has been a constant feature of the investing landscape during the past few years. In fact, you need to go back to the 1970s to find another period when interest rate volatility was consistently at or below its current level (Chart 1). Not surprisingly, the implied volatility priced into Treasury options is also as low as it has been during the past 30 years, with the exception of the period just prior to the financial crisis in 2007 (Chart 2). Chart 1Yield Volatility: Lowest Since The 70s Chart 2Implied And Realized Yield Volatility Move Together This begs the question of whether the current low-vol environment can be sustained, or whether overly complacent investors are in for a shock. At the very least, we believe that rate volatility has already passed its cyclical trough and will start to move up this year. Investors should prepare themselves for higher volatility. In this week's report we examine the key macro drivers of interest rate volatility and discuss the implications of rising vol for both Treasury yields, and crucially, mortgage-backed securities. Macro Uncertainty & Rate Volatility Chart 3Macro Drivers Of Rate Volatility In a Special Report published in 2014,1 we posited that the long-term trends in volatility across all asset classes are largely driven by common macroeconomic factors. Specifically, investor uncertainty regarding the outlook for economic growth and monetary policy. A 2004 paper by Alexander David and Pietro Veronesi2 provides some theoretical justification for this view, as the authors observed that investors tend to overreact to new information when macro uncertainty is high, and underreact when uncertainty is low. To test the linkage between interest rate volatility and macro uncertainty we consider three measures of uncertainty. The first two measures, shown alongside the MOVE index of implied Treasury volatility in Chart 3, are measures of GDP growth and T-bill rate forecast dispersion. We measure dispersion - the disagreement among forecasters - by looking at individual forecasts of GDP growth and T-bill rates and calculating the difference between the 75th and 25th percentiles. The series shown in Chart 3 are equal-weighted averages of the forecast dispersion calculated for five different time horizons, ranging from the current quarter to four quarters ahead. As can be seen in the top two panels of Chart 3, implied interest rate volatility is higher when the disagreement among forecasters is greater, consistent with our thesis. The third measure of uncertainty we consider is the Global Economic Policy Uncertainty Index created by Baker, Bloom and Davis.3 This index tracks uncertainty about the macro environment by counting the number of mentions of certain key words in major global newspapers. Elevated readings from this index have also coincided with high rate volatility in the past (Chart 3, bottom panel). GDP Growth Forecast Dispersion Chart 4Forecast Dispersion & Corporate Lending Disagreement among GDP growth forecasts reached an all-time low in the fourth quarter of 2016, but has since recovered to slightly more typical levels. Historically, we have found that C&I lending standards and corporate sector balance sheet health correlate most closely with GDP growth forecast dispersion (Chart 4) and both measures suggest that forecast dispersion is biased upward. T-Bill Rate Forecast Dispersion T-bill rate forecast dispersion was abnormally low between 2011 and 2014 for two reasons. The first reason is quite simply the zero-lower-bound on interest rates. A short rate bounded at zero necessarily trimmed the distribution of possible T-bill rate forecasts, since forecasters logically assumed that further interest rate cuts were not possible. This impact will gradually dissipate the further the fed funds rate moves off zero. Chart 5Fed Says March Meeting Is Live The second reason for extremely low T-bill rate forecast dispersion was the Fed's forward guidance. During this timeframe the Fed was actively trying to convince the public that interest rates would remain low. The most obvious example being the "Evans Rule", where the Fed promised not to lift interest rates at least until the unemployment rate had fallen below a specific threshold. This activist forward guidance limited the range of conceivable T-bill rate forecasts and crushed interest rate volatility. Nowadays, the Fed is engaged in a different sort of forward guidance, trying to convince markets that every FOMC meeting is live and that rate hikes could occur at any moment. Essentially, the Fed is trying to inject volatility into the rates market. Just a few weeks ago, when asked about the low probability markets are assigning to a March rate hike (Chart 5), San Francisco Fed President John Williams replied flatly: "I don't agree. All our meetings are live." Global Economic Policy Uncertainty We have written a lot about the policy uncertainty index in recent reports,4 focusing specifically on how it has diverged from its historical relationships with many asset prices. At the very least, we expect that sustained elevated policy uncertainty will place upward pressure on asset price volatility at the margin. Bottom Line: Forecast disagreement about GDP growth and T-bill rates will increase over the course of the year. This, alongside elevated policy uncertainty, will translate into higher interest rate volatility. Rate Volatility & Treasury Yields Long-dated nominal Treasury yields can be decomposed in a few different ways. In recent reports we have focused on the decomposition of the nominal 10-year Treasury yield into its real and inflation components. By identifying different macro drivers for each component we concluded that nominal Treasury yields will increase this year, driven by a rising inflation component and relatively stable real yields.5 Alternatively, we can think of the nominal 10-year Treasury yield as consisting of an expectations component equal to the market's expected path of short rates over the next ten years, and a term premium that reflects all of the other market imbalances and uncertainties associated with taking duration risk. This second approach is complicated by the fact that it requires a model of ex-ante interest rate expectations and every commonly used model is fraught with its own unique difficulties.6 Setting that aside, if we use the Kim & Wright (2005)7 estimate of the 10-year term premium we observe an expectations component that generally tracks the fed funds rate and a term premium component that is correlated with implied Treasury volatility (Chart 6), although the latter correlation is less than perfect. This decomposition also suggests that nominal Treasury yields should rise. The Fed is much more likely to hike rates than cut them and we have concluded that rate volatility is likely to trend higher from current depressed levels. However, the relationship between rate volatility and the term premium is complicated. The main reason for the complicated relationship between interest rate volatility and the term premium is the fact that elevated interest rate volatility also tends to be correlated with high equity volatility (Chart 7). So while higher rate volatility puts upward pressure on the term premium, the associated increase in equity volatility tends to raise investor risk aversion and increase the perceived value of bonds as a hedge against equity positions. This mitigates some (or often all) of the impact of rising rate volatility on the term premium. Chart 6Which Way For The ##br##Term Premium? Chart 7MOVE & VIX Have Opposing##br## Impacts On Bond Yields Bottom Line: Higher rate volatility should cause the term premium in the Treasury curve to increase at the margin. However, this impact could be offset if rate volatility and equity volatility rise in concert. An increase in equity vol would encourage flight-to-safety flows into bonds. Rate Volatility & MBS The relationship between rate volatility and MBS is much more straightforward than for Treasury yields. We observe a tight correlation between nominal MBS spreads and the MOVE implied volatility index (Chart 8). Chart 8 suggests that, even in the near-term, MBS spreads are too low for current levels of rate vol. The relationship between MBS spreads and rate volatility is easily explained. The defining characteristic of a negatively convex asset, such as MBS, is that its duration is positively correlated with the level of interest rates (Chart 9). This correlation leads to increased losses when yields rise and lower gains when yields fall. It's not surprising that negatively convex assets perform best in low volatility environments. Chart 8MBS Spreads Are Linked To Vol Chart 9MBS Duration Moves With Yields We maintain an underweight allocation to MBS given that spreads are already low and that the volatility environment is poised to become less favorable. Further, if the Fed continues along its planned normalization path it is likely to cease the reinvestment of its MBS portfolio at some point in 2018. There are two reasons why this poses a risk for MBS. The first reason is that the unwinding of the Fed's MBS portfolio is likely to place upward pressure on implied volatility. While private investors often hedge their MBS positions by purchasing volatility, the Fed has no incentive to do so. It follows that by removing a large stock of MBS from private hands the Fed has also removed a large source of demand for volatility. When this supply is re-introduced into the market, demand for volatility is likely to increase. The second reason relates more directly to the supply and demand balance for MBS. In years when net MBS issuance (adjusted for Fed purchases) has been negative, excess MBS returns have tended to be positive (Chart 10). Further, while negative net MBS issuance (adjusted for Fed purchases) has been the norm since Fed asset purchases began in 2009 (Chart 11), this state of affairs will change once the Fed starts to unwind its MBS portfolio. Chart 10Annual MBS Excess Returns ##br## Vs. Net Supply Since 1989 Chart 11Net Issuance Will Turn##br## Positive In 2018 During the past three years the Fed has been buying between $20bn and $40bn MBS per month, just to keep its balance sheet stable. Net new MBS issuance will not be strong enough to overcome this hurdle in 2017, but net MBS issuance (adjusted for Fed purchases) will swing quickly into positive territory in 2018 if the Fed decides to let its MBS portfolio run down. Bottom Line: Higher interest rate volatility and the unwinding of the Fed's mortgage portfolio will lead to wider MBS spreads during the next two years. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy / Global Fixed Income Strategy Special Report, "Volatility, Uncertainty And Government Bond Yields", dated May 13, 2014, available at usbs.bcaresearch.com 2 "Inflation and earnings uncertainty and volatility forecasts", Alexander David and Pietro Veronesi, Manuscript, Graduate School of Business, University of Chicago (2004). 3 Please see www.policyuncertainty.com for further details. 4 Please see Theme # 4 in U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Is It Time To Cut Duration?", dated January 17, 2017, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "Bond Volatility - The Unwelcome Guest That Will Not Leave", dated June 16, 2015, available at usbs.bcaresearch.com 7 Don H. Kim and Jonathan H. Wright, "An Arbitrage-Free Term Structure Model and the Recent Behavior of Long-Term Yields and Distant-Horizon Forward Rates", FEDS 2005-33. https://www.federalreserve.gov/econresdata/feds/2005/index.htm Fixed Income Sector Performance Recommended Portfolio Specification

Highlights The divergence in political uncertainty measures and the VIX index suggests that equity prices are vulnerable to Washington disappointments. Longer term, a self-reinforcing, low-inflation recovery is in place, which sets a fundamentally positive cyclical backdrop for equities. Monetary policy is still in a sweet spot for risk assets. Fed policy decisions throughout the current cycle have been in line with the Taylor Rule, once the model is adjusted for regional growth disparities. The most recent Senior Loan Officer Survey runs counter to most other data on the consumer. Improved consumer confidence should lead to stronger consumer loan demand, while banks should be more willing to lend when their customers have jobs and rising incomes. Feature Equity market performance over the past few weeks has been impressive. Still, there are starting to be signs that investors are becoming nervous. Safe-haven assets have been undergoing a stealth recovery since mid-December: gold, the Japanese yen, and the Swiss franc have all appreciated (Chart 1). In relation to these trends, the equity market is the so-called "odd man out": even though several safe-haven assets bottomed out mid-December, the stock market continued to make new highs. A second worrying divergence is the behavior of two popular risk indexes: the VIX and the Global Policy Uncertainty Index. The former - a measure of the cost of equity insurance - remains very low, while political uncertainty is making record highs. In fact, Chart 2 shows that the gap between these two risk measures is at a historic extreme. This reinforces our view that the equity market is vulnerable to negative surprises. Chart 1A Message From Safe Havens? Chart 2Different Signals? One main risk is that investors will become disappointed with the timing and magnitude of market-friendly policies from Washington. Meanwhile, the possibility of less friendly policies being passed is rising. Our Geopolitical team believes that the Trump administration will ultimately accept the House GOP's Border Adjustment Tax (BAT) proposal, though the road between here and there will be tortuous, as past attempts at tax reform show.1 We would expect market volatility to rise as the BAT debate intensifies. Longer term, the economy is entering a self-reinforcing phase. And since it is premature to expect inflation to flare up to a point that would require aggressive monetary tightening,2 we expect that the cyclical bull market will be prolonged. Policy Sweet Spot We have shown on several occasions3 that equities perform well in the early phases of a rising interest environment, i.e. for as long as rates remain in accommodative territory. We have identified four phases of the fed funds rate cycle, which are defined by the policy rate relative to its equilibrium level (accommodative or restrictive) and the direction of its last move: Phase I = Policy is accommodative, but the Fed funds rate is rising. Phase II = Policy is tight and the Fed funds is still rising. Phase III = Policy is tight, but the Fed is cutting rates. Phase IV = Policy is easing and the Fed is cutting rates. As one would expect, the best equity market returns occur when the Fed funds rate is accommodative (below the equilibrium rate) and the Fed is still cutting and/or on extensive hold, i.e. Phase IV. The second best phase for equity performance is the current one: when policy is still accommodative, but rates are rising (Chart 3). Granted, the magnitude of returns in this phase depend markedly on earnings performance, but the general message is that risk assets will continue to eke out positive gains, so long as the Fed finds reason to stay accommodative. Chart 3Policy Sweet Spot Can Last A Long Time To this end, this week we examine the Taylor rule - which prescribes a value for the federal funds rate based on the values of inflation and economic slack - and its usefulness in the current economic (and political) environment. The Robotization Of The Fed In mid-January, FOMC Chair Janet Yellen gave a speech4 that outlined the merits of using statistical rules to guide monetary policy. Her speech served as a rebuttal to the FORM Act (Fed Oversight Reform and Modernization Act). The FORM Act - whose main feature is to have Fed officials determine a mathematical formula to guide their interest-rate decisions - is only one of several measures that have been proposed over the years to revamp the Fed to put it under greater Congressional scrutiny and limit its discretionary powers. The Senate has never voted on the FORM Act, but Yellen's speech on rule-based approaches to monetary policy suggest that this type of legislation should be on investors' radars. In the past, plenty of simple policy rules have been suggested to guide central banks' decisions.5 But in her speech, Yellen spoke about the relevance of the Taylor Rule. The Taylor rule calls for systematic adjustments in the federal funds rate relative to its expected longer-run neutral level in response to movements in inflation and the output gap, defined as the percentage difference between actual output and the economy's productive potential. The traditional Taylor Rule shows that the Fed is currently behind the curve and should be much more hawkish (Chart 4, top panel). Chair Yellen's preferred variant is to use a "balanced approach," which is twice as responsive to the movements in resources utilization (Chart 4, bottom panel). Simply put, it doubles the coefficient of the output gap, putting more emphasis on maintaining sustainable growth. But even with this methodological tweak, Yellen warned of the danger of using simple rules to conduct policy and quoted the uncertain footing of the global economic growth pattern. She also highlighted that the uncertainty related to upcoming fiscal policy: "simple rules ignore such important factors as fiscal policy, trends affecting global growth, structural developments influencing supply of credit, and overall financial conditions." For this reason, we created an Augmented Taylor rule that improves on the Traditional as well as Yellen's preferred modified Taylor rule. Our version of the Taylor rule has a better track record in explaining the Fed's policy decisions historically. Chart 4Taylor Vs. The Fed Chart 5Different Rates For Different States Augmenting The Taylor Rule One of the difficulties in conducting monetary policy in the U.S. is that growth is unevenly distributed. For example, according to the BEA, state level real GDP growth varied between -0.1% (In Alaska and New Mexico) and 7.1% (in South Dakota). Regulating interest rates over such an eclectic base has the potential to create distortions. Therefore, determining a mathematical formula for monetary policy should take into account these asymmetric patterns. By studying state-specific variables, we augment the Taylor Rule and come up with a more accurate reading of the Fed's behavior. The Augmented Taylor Rule is calculated using an average of 51 state-specific Taylor rules,6 using state GDP deflator and state unemployment rate as inputs. Please note that the following work does not make us advocates for the Fed following a mathematical formula. However, our model does better formulize the Fed's historical actions. To construct our Augmented Taylor rule we do the following: Step 1 - State Taylor Rules: NAIRU and the Fed's targets for interest rates and for inflation were used at the national level. As such, we used state-specific variables for the rest of the variables. Specifically, we used each states' GDP deflator and unemployment rate as inputs for inflation and resource utilization, respectively. With these variables, we calculated each states' Taylor Rule using Janet Yellen's preferred formula, the balanced approached. We then aggregated the data by calculating a simple average of the 51 Taylor Rules. As a reference, the top panel of Chart 5 shows that the averaged state Taylor Rules and Yellen's balanced approach are similar despite slightly different methods. Step 2 - Quantifying Asymmetry: As the middle panel of Chart 5 shows, there are large divergences between states' Taylor Rule-prescribed interest rates throughout time. Therefore, we calculated the standard deviations of the Taylor Rules across the 51 states Taylor Rules to come up with a value of asymmetry measure (Chart 5, bottom panel). Step 3 - Augmenting The Taylor Rule: We then deducted the asymmetry measure from the average Taylor Rule (Chart 6). The rationale for doing so is that it is much more difficult for the Fed to raise rates when outputs gaps vary greatly across states. Step 4 - Validating The Rule: Chart 7 shows the relationship between the national balanced Taylor rule (i.e. Yellen's preferred approach) and the Fed funds rate, and the augmented Taylor rule and the Fed funds rate. The main difference between our adjusted Taylor rule and Yellen's balanced approach is that we give equal weight to each state Taylor rule and then subtract the variance across states. Recall that both the Traditional and Balanced Taylor rules use national aggregate data, and do not account for state variances. The augmented Taylor Rule improves the R2 over the national rule, therefore providing more explanatory power of the Fed's decisions. Chart 6The Fed Is Constrained By Asymmetry Chart 7Validating The Augmented Taylor Rule The bottom line is that the Augmented Taylor Rule allows us to understand and quantify the economic asymmetry within the U.S. Further, it appears as though the Fed has been following this rule even if policymakers are not aware of it! Given the current message from our rule, investors should expect the Fed to remain gradual in raising rates. We do not foresee the Fed "catching up" with the Traditional Taylor (which currently calls for a policy rate of over 4%). The above Taylor Rule analysis corroborates our view that policy will stay in a sweet spot for equities. The bond market currently is priced for two rates in the next twelve months. If that is realized, interest rates would still be below the equilibrium rate, underscoring that monetary policy will be a benign factor for risk assets. Economy Update: Too Early To Worry About Rising Rates The most recent Fed Senior Loan Officer Opinion Survey, completed after most of the run up in interest rates, showed that banks' lending standards for loans to businesses remained largely unchanged, though lending standards for consumer loans stiffened, especially for auto loans and credit cards (Chart 8). There was also reportedly less demand for consumer credit. These results run counter to most other data on the U.S. consumer. As we highlighted in previous reports, consumer confidence has soared to its highest level in the cycle and the labor market is approaching full employment. These trends should lead to stronger consumer loan demand, while banks should be more willing to lend when their customers have jobs and rising incomes. This was not borne out in the Fed's Q1 lending survey, especially as it relates to auto and credit card loans: banks expect the asset quality of auto and credit card loans to further deteriorate this year. These survey results are difficult to ignore as they tend to correlate reasonably well with consumer spending patterns. We maintain an optimistic view on household spending for 2017, driven by the strong labor market, though the next survey (to be released in early May) will tell whether the Q1 results were an aberration or the start of a weaker trend. Importantly, recent work from our Bank Credit Analyst service7 concluded that household interest payment burdens will rise only modestly, and from a low level, over the next couple of years even if borrowing rates increase immediately by 100bps for today's levels. According to their analysis, it would require a much more significant shock, i.e. 300bps or greater, to move interest payments as a share of GDP back toward historical averages. Projections are shown in Chart 9. Chart 8Banks Are Still Cautious On Lending Chart 9Rising Rates Are Not Problematic More broadly for the major economies, global debt has soared by over 40 percentage points since 2007. However, The BCA report uncovers that a doomsday scenario for global growth due to a rising interest rate environment (led chiefly by the Fed) is unlikely to unfold. First, the starting point for debt service burdens in the corporate, household and government sectors is low. These burdens have generally trended down since 2007 because falling interest rates have more than offset debt accumulation, with the major exception of China. Second, the maturity distribution of debt means that it takes time for interest rate shifts to filter into debt servicing costs. For example, the average maturity of corporate investment-grade bond indexes in the major economies is between 3 and 12 years. The average maturity of government indexes range from 7½ to 16 years. Moreover, the majority of household debt is related to fixed-rate mortgages. Even a significant portion of consumer debt is fixed for 5 years and more in some countries. Third, even following the backup in yield curves since the U.S. election, current interest rates on new loans are still significantly below average rates on outstanding household loans, corporate debt and government debt. The implication is that most older loans and bonds coming due over the next few years will be rolled over at a lower rate compared to the loans and bonds being replaced. This will even be true if current yield curves shift up by 100bps in many cases (except for the U.S. where current yields are closer to average coupon and loan rates). The bottom line is that a rising interest rate backdrop will only become problematic much later in the economic cycle. In the meantime, the strength of the consumer spending upcycle depends on (stronger) income trends and banks' willingness to spend. We are optimistic about the former and will continue to monitor the latter. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com David Boucher, Editor/Strategist davidb@bcaresearch.com 1 Please see Geopolitical Strategy Weekly Report, "Will Congress Pass The Border Adjustment Tax?," dated February 8, 2017, available at gps.bcaresearch.com. 2 Please see U.S. Investment Strategy Weekly Report "Inflation In 2017: An Idle Threat," dated January 9, 2017, available at usis.bcaresearch.com. 3 Please see U.S. Investment Strategy Weekly Report "Lingering In The Policy Sweet Spot," dated September 26, 2016 and "Stocks And The Fed Funds Rate Cycle," dated December 23, 2013, available at usis.bcaresearch.com. 4 Please see a transcript of Janet Yellen's January 19, 2017 speech, https://www.federalreserve.gov/newsevents/speech/yellen20170119a.htm 5 Taylor, J. and Williams, J. "Simple and Robust Rules for Monetary Policy," Federal Reserve Bank Of San Francisco, Working Paper Series, Dated April 2010. 6 We used the 50 states and the District of Columbia. 7 Please see, The Bank Credit Analyst Special Report "Global Debt Titanic Collides With Fed Iceberg?," dated February 2017, available at bca,bcaresearch.com. Appendix Monthly Asset Allocation Model Update Our Asset Allocation (AA) model provides an objective assessment of the outlook for relative returns across equities, Treasuries and cash. It combines valuation, cyclical, monetary and technical indicators. The model was constructed as a capital preservation tool, and has historically outperformed the benchmark in large part by avoiding major equity bear markets. Please note that our official cyclical asset allocation recommendations deviate at times from the model's recommendation. The model is just one input to our decision process. The model's recommendation for cash has been upgraded to benchmark at the expense of bonds. The weightings for the major asset classes are: neutral equity exposure at 60% (benchmark 60%), neutral Treasury allocation at 30% (benchmark 30%) and cash at 10% (benchmark 10%). The diffusion index of the three components for The Equity Model remained neutral. The technical component retained its "buy" signal, with slight advances for both the breadth & trend and momentum indicators. The monetary component, which measures overall liquidity conditions, though still favorable for equities, is giving a less bullish signal. The earnings-driven component continues to give a cautious signal. Even as real operating earnings continue to gradually improve, they still remain at a significant distance from positive economic expectations which have moved higher yet again. Earnings momentum is also still sluggish, based on our earnings diffusion index. The model's recommendation for bonds is now at benchmark which fits with our neutral qualitative stance for Treasuries in balanced portfolios since November 7, 2016. Although the valuation and cyclical components of the bond model are still constructive, the deterioration of the technical component triggered a "sell" signal changing the allocation from overweight tot benchmark. Chart 10Portfolio Total Returns Chart 11Current Model Recommendations Note: The asset allocation model is not necessarily consistent with the weighting recommendations of the Cyclical Investment Stance. For further information, please see our Special Report “Presenting Our U.S. Asset Allocation Model”, February 6, 2009.

Highlights The USD bull case is now well known by the market, but this is not strong enough a hurdle to end the dollar's run. The behavior of positioning, the U.S. basic balance of payments, interest rate expectations, and relative central bank balance sheets suggest we are entering the overshoot phase of the rally. Volatility will increase and differentiation on the dollar's pairs is becoming more important. Reflation plays are especially in danger, and the euro could be handicapped by political risk. The yen remains the preferred mean to play the ongoing dollar correction. Feature The dollar bull market has been echoing the path traced in the 1990s (Chart I-1). The key question for investors now is whether the dollar can continue to follow this road map or is the bull market over. The dollar bullish arguments are now well known by market participants, increasing the risk that purchases of the dollar might exhaust themselves. We review the indicators that worry us most and conclude that the dollar bull market could run further. However, as the dollar is now moving into overshoot territory, we expect that the volatility of the rally will only grow. Also, divergences in the dollar on its pairs are becoming more likely. We remain short USD/JPY, and explore the risks to the euro's near-term outlook. Signs Of An Overshoot? Sentiment The first factor that worries us about the future of the USD bull market is the near universality of the positive disposition of investors toward the dollar. However, two observations are in order. First, both sentiment and net speculative positions are not nearly as stretched as they were at the top of the Clinton USD bull market (Chart I-2). Second, it took six years of elevated bullishness and long positioning to prompt the end of the bull market in 2002. Either way, the dollar can continue to climb despite this handicap. Chart I-1Will History Repeat Itself? Chart I-2In The 1990s, The Consensus Was Right This reflects the fact that currency markets can often fall victim to something called the "band-wagon" effect, where a strong trend attracts more funds and perpetuates itself. Chart I-3America Is Great Again, ##br##At Least According To Investors We think this is caused by two factors. Valuation signals in the currency market have a poor track record at making money on a less than 2-year basis. This means that such signals need to be extremely strong before investors act on them. The dollar being 10% overvalued does not fit this description, instead a 20% to 25% overvaluation would hit that mark. Also, a strong upward move in a currency attracts funds to that economy. This creates liquidity in that nation's banking sector, alleviating some of the economic pain created by a rising currency or the tighter monetary policy that often caused the currency in question to rise in the first place. Today, the U.S. economy fits this bill, as private investors are rapaciously grabbing U.S. assets (Chart I-3). The Basic Balance Of Payments We have been struggling with how to interpret a strong basic balance of payment position. On the one hand, an elevated basic balance suggests that there is buying out there supporting a nation's currency. On the other hand, a strong basic balance position, especially if not caused by a current account surplus, suggests that market participants have already implemented their purchases of that nation's currency's and assets. These investors thus need further positive shocks to buy even more of that currency in order to lift its exchange rate ever higher. Today, the basic balance of payments in the U.S. is at a record high of 3.8% of GDP, begging the question of how it can climb higher from here (Chart I-4). However, as the same chart reveals, each of the previous dollar bull markets ended a few years after the U.S. basic balance of payments had peaked. Thus, we currently continue to expect the dollar to strengthen even if the U.S. basic balance position were to deteriorate. Additionally, the euro area basic balance is very depressed today at -3.4% of GDP, despite a current account surplus of 3% of GDP. However, in 1999, the region's basic balance bottomed at -5.6% of GDP, and it took until 2002 before the euro could durably rally, at which point the euro area basic balance had move back near 0% of GDP. Therefore, we would need to see a marked improvement in the euro area's basic balance in order to buy and hold the euro on a 12-to-18 months basis. Interest Rate Expectations Investors have rarely been as convinced as they are today that the Fed will increase interest rates over the coming months. This implies that the room for disappointment is large. However, as Chart I-5 illustrates, this is still not a reason to begin betting on an end to the dollar cyclical bull market. An overshoot in the dollar is marked by a fall in expectations of interest rate hikes as the strong dollar hurts the economy, preventing the Fed from hiking as much as anticipated. Moreover, except in 1994, a decreasing prevalence of rising rate expectations has lead dollar bear markets by more than a year. This suggests that there is room for the dollar to strengthen even if markets downgrade their U.S. rates expectations. Chart I-4The Basic Balance##br## Is A Small Hurdle Chart I-5In An Over Shoot, The Dollar Can Rally ##br##Even If Investors Doubt The Fed Even when looked comparatively, the broad consensus of investors regarding the continuation of monetary divergences between the Fed and the ECB is not yet a hurdle for the dollar to continue beating the euro on a 12-18 months basis. Not only is EUR/USD currently trading in line with relative expectations, previous euro rallies have been preceded by a big upgrade of the expected path of policy in Europe relative to the U.S. We currently expect the ECB to go out of its way to telegraph that even if asset purchases get curtailed in the second half of 2017, this will in no way foretell an imminent increase in European rates. Meanwhile, the Fed is in a firm position to increase rates as U.S. slack has dissipated (Chart I-6). Moreover, the proposed fiscal stimulus of the Trump administration should create inflationary pressures in this environment, solidifying the Fed's resolve to hike rates further. Chart I-6The Fed Pass Toward Higher Rates In Being Cleared Balance Sheet Positions One indicator concerns us more than the others at this point in time. As we wrote two weeks ago, one factor that has propelled the dollar higher has been its relative scarcity. The limited supply of dollar in the offshore markets - courtesy of the meltdown in the prime money-market funds industry and the heavier regulatory burden on banks - has caused cross-currency basis swap spreads to widen, pushing the greenback higher.1 Chart I-7Balance Sheet Dynamics And##br## The Scarcity Of Dollars Currently, the cross-currency basis swap spreads are hovering near record lows. However, as Chart I-7 illustrates, the surplus of euros created by the ECB's balance-sheet expansion as the Fed stopped its own purchases had a role to play in this phenomenon. While we expect the ECB to stand pat on the interest rate front for the foreseeable future, a further tapering of asset purchases in the second half of 2017 and beyond is very likely. This could limit the widening in cross-currency basis swap spreads that has been so helpful to the dollar, especially if the Fed elects not to curtail the size of its balance sheet. Net Net Many indicators suggest that the potential for dollar buying may be on the verge of exhausting itself. However, when looked closer, while these factors are a cause for concern, they still do not preclude an overshoot in the dollar. In fact, if anything, they suggest that the dollar is only now beginning its overshoot phase, a leg of the bull market that historically begins to inflict deeper pain on the U.S. economy as the dollar gets ever more dissociated from its fundamentals. So What? While the above indicators do not yet point to an end of the bull market, they in no way suggest that the dollar cannot suffer episodic corrections. We believe we are in the midst of such an event. Can the correction last further? Yes. To begin with, while the heavy net long positioning in the dollar does not represent much of a cyclical hurdle to beat, it does still constitute an important tactical risk. Our models corroborate this view. DXY is only currently fairly valued based on our intermediate-term timing model. Historically, tactical corrections fully play out once this model is in cheap territory (Chart I-8). Moreover, our capitulation index paints a similar story. This indicator has corrected some of its overbought excesses but remains above levels suggestive of an oversold environment. To the contrary, the fact that this index is still below its 13-week moving average points to additional selling pressures on the USD (Chart I-9). Chart I-8The Dollar Tactical Correction Is Not Over Chart I-9Confirming The Dollar Tactical Downside However, other factors suggest that the dollar could strengthen on certain pairs. The outlook seems especially grim for the reflation plays like the commodity currencies. Our reflation gauge, based on the prices of lumber, industrial metals, and platinum, has moved upward exactly as the U.S. dollar has rallied, a short-lived phenomenon that happened in 2001, 2002, and 2009. In all these cases, the Fed was easing policy and U.S. rates were softening relative to the rest of the world (Chart I-10). We doubt this phenomenon can continue much longer, especially as the Fed is currently tightening policy and U.S. rates are rising relative to the rest of the world. Moreover, Chinese fiscal stimulus was crucial in supporting this divergence in both 2009 and 2016. However, Chinese government spending went from growing at a 25% annual rate in November 2015, to a near 0% rate now. Moreover, the PBoC has already increased rates twice on its medium-term facilities and has also stopped injecting liquidity in the interbank market despite recent upward pressures on the SHIBOR. This tightening could prove problematic for natural resources like coking coal, iron ore, or copper, commodities highly levered to the Chinese real estate market and of which China recently accumulated large inventories (Chart I-11). Chart I-10An Unusual Move Chart I-11Elevated Chinese Metal Inventories Additionally, on the back of the longest expansion in the global credit impulse in a decade, G10 economic surprises have become very perky. However, it will be difficult to beat expectations going forward. Not only have investors ratcheted up their global growth expectations, the recent increase in global interest rates limits the capacity of the credit impulse to grow further. In fact, the recent tightening in U.S. banks credit standards for consumer loans, the fall in the quit rates in the U.S. labor market, and the underperformance of junk bonds relative to Treasurys since late January only re-inforce this message. Sagging global growth, even if temporary, is always a problem for commodities and commodity currencies. The euro faces its own risk: France. Last week, along with our colleagues from BCA's Geopolitical Strategy service, we wrote that the chance of a Le Pen electoral victory is still extremely low and we would buy the euro on any sell-off caused by a rising euro-area breakup risk premium.2 Yet, we are not oblivious to the risk that before the second round of the election is over on May 7th, investors can continue to place bets that Marine will win and that France will exit the euro area. The recent widening of the OAT/Bund spread reflects these exact dynamics as François Fillon's hardship and Macron's love life have taken center stage. So real has been the perception of this risk that spreads on Italian and Spanish bonds have followed suit (Chart I-12). While we are inclined to lean against this move, it is a risk that investors may want to bet on or hedge against. At the current juncture, the euro is fully pricing in these developments, and no mispricing is evident. However, as our model based on real rates differentials, commodity prices, and intra-European spreads shows, if France spreads were to widen further, EUR/USD could suffer (Chart I-13). In fact, if French spreads retest their 2011 levels, the euro could fall toward parity. Chart I-12Le Pen Is Causing A Repricing ##br##Of The Euro Area's Breakup Chance Chart I-13The Euro Will Suffer If French ##br##Bonds Underperform Further Investors wanting to speculate on the French election but wanting to avoid taking on some USD exposure can do so by shorting EUR/SEK, a very profitable strategy when the euro crisis was raging (Chart I-14) or could short EUR/GBP, as interest rates expectations have begun to move against the common currency and in favor of the pound (Chart I-15). While EUR/CHF tends to weaken during times of euro-duress, it is currently trading close to the unofficial SNB floor and we worry that growing intervention by the Swiss central bank will limit any downside on this pair. The currency that is likely to benefit the most against the dollar remains the yen. Not only are investors still very short the yen, but based on our intermediate-term timing model, the yen remains very attractive (Chart I-16). Moreover, the recent large improvement In the Japanese inventory-to-shipment ratio only highlights that the Japanese economy has gathered momentum, decreasing the likelihood of an enlargement of the current set of ultra-stimulative measures from the BoJ. Chart I-14Short EUR/SEK: A Hedge Against Le Pen Chart I-15Downside Risk For EUR/GBP Chart I-16Yen: Biggest Winner If USD Corrects Additionally, any risk-off event caused by a correction of the reflation trade would benefit the yen. Falling commodity prices will hurt Japanese inflation expectations and lift real rate differentials in favor of the yen. A correction in the reflation trade would also put downward pressure on global bond yields, which means that due to the low yield-beta of JGBs, Japanese nominal interest rates spread would further contribute to a narrowing of real interest rate differentials in favor of the JPY. Finally, if investors begin to bet even more aggressively on a breakup of the euro area fueled by the perceived prospects of a Le Pen electoral victory, the vicious wave of risk aversion unleashed around the globe by such an event would likely support the yen beyond our expectations. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please refer to the Foreign Exchange Strategy Weekly Report, "Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism", dated January 27, 207, available at fes.bcaresearch.com 2 Please refer to the Foreign Exchange/ Geopolitical Strategy Special Report, "The French Revolution", dated February 3, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 As we highlighted in previous reports, DXY's losses extended no further than the 99-100 support range, and the index has rebounded since then. A key external driver of the USD is EUR, whose roll-over has coincided with the DXY's rebound. In the coming months, EUR/USD could display downside risk as markets price in election jitters. This could be bullish for the greenback. The budget plan is in discussion. Due in around a month, the tentative plan comprises tax cuts and defense spending mostly. While this is still speculative, this plan may be bullish for the dollar. Until then, it is likely that the DXY will follow in its seasonal trend and be largely unchanged with little upside this month. Report Links: Risks To The Cyclical Dollar View - February 3, 2017 Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism - January 27, 2017 U.S. Border Adjustment Tax: A Potential Monster Issue For 2017 - January 20, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Two main factors are weighing on the euro this week. Firstly, Draghi continues to retain his dovish stance. He stated that there is still "significant degree of labour market slack", which is limiting wage growth, a key contributor to underlying inflation. Secondly, and more substantial, are politically-induced anxieties in the run up to the European elections. In particular, French elections have increased risk premia, forcing the 10-year OAT-Bund spread to reach early-2014 highs. Greek 2-year yields have also spiked above 10%. Volatility is likely to be elevated in the lead up to the French election and possibly through Italian elections. The longer-term outlook will remain dictated by the development of the ECB's monetary policy stance. Report Links: The French Revolution - February 3, 2017 GBP: Dismal Expectations - January 13, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Then yen continues to rally, with USD/JPY already down by almost 5% this year. Uncertainty surrounding the European elections should help continue this trend, given that the yen should benefit from safe haven flows. Nevertheless, the outlook for the yen remains bearish on a cyclical basis, as the measures that the BoJ has taken, such as anchoring 10-year rates near 0, and switching to de facto price level targeting will eventually lower Japanese real rates vis-à-vis the rest of the world. The BoJ has taken these measures to kick start an economy plagued by deflation. Early returns from this policy are mixed: Machinery Orders grew by 6.7% YoY, outperforming expectations. However both housing starts growth and Nikkei Manufacturing PMI fell below expectations, coming at 3.9% and 52.7 respectively. Report Links: Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism - January 27, 2017 Update On A Tumultuous Year - January 6, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 On Wednesday, the U.K. House of Commons finally gave their approval to a bill authorizing the government to start exits talks with the European Union. The House of Lords will be the next hurdle that Brexit hopefuls will have to overcome. Although cable suffered from some volatility following the decision it has remained relatively unaffected. We continue to think that the pound has further upside, particularly against the euro, as the negative consequences of Brexit on the British economy are already well priced into cable. Furthermore, increasing uncertainty regarding the French elections should also be bearish for EUR/GBP. If the fear of a Le Pen presidency starts to increase, Brexit will become an afterthought as exiting the European Union takes on a completely different meaning if the integrity of the EU starts being put into question. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The RBA held rates at 1.5% this week on the basis of upbeat business and consumer confidence, and above-trend growth in advanced economies. This decision helped the AUD, as investors repriced dovish bets and interpreted a change in stance. While above-trend growth is possible, Chinese demand is particularly important for Australia. Last week, the PBoC silently tightened their 7-, 14-, and 28-day reverse repo rates by 10 bps each to help alleviate looming risks in the real estate market and general financial stability. This may signal an end to an easing cycle, which may limit demand growth going forward. Australia has its own financial worries. Household debt is at its highest ever, at 186% of disposable income, which would be catastrophic if rates are raised. Lowe also highlighted concerns about a strong AUD and its impact on Australia's economic transition. Report Links: Risks To The Cyclical Dollar View - February 3, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 The RBNZ decided to keep interest rates unchanged at 1.75% in their monetary policy meeting this Wednesday. Additionally, as expected, Governor Graeme Wheeler stated that the RBNZ had shifted from having a dovish bias to a having neutral one. Nevertheless, the kiwi has depreciated sharply since the announcement, not only because Governor Wheeler highlighted that the currency "remains higher than is sustainable for balanced growth" but also because the RBNZ showed a cautious approach by stating that "premature tightening of policy could undermine growth and forestall the anticipated gradual increase in inflation". However, we believe that the RBNZ will turn more hawkish, as inflationary forces in the economy will eventually put upward pressure on rates. This will lift the NZD, particularly against the AUD. Report Links: Risks To The Cyclical Dollar View - February 3, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Uncertainty has come up as a key issue in the Bank of Canada's headlights, as Poloz remains nervous about the future of U.S.-Canada relations. CAD has recently displayed some strength despite this uncertainty. It has appreciated against USD, AUD and NZD. This is likely due to a brightening perception of the Canadian economy with the Ivey PMI recording a reading above 50 for January, at 52.3, above the previous 49.3. Additionally, housing starts beat expectations, dampening housing market concerns. Exports have been strong, which has also fed into this appreciation. A rapidly appreciating currency would exacerbate trade concerns further and adversely affect the Canadian economy. Therefore, it is likely that the BoC remains tilted to the dovish side, which will generate downside for the CAD through rate differentials. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 EUR/CHF has reached its lowest level since August 2015. At around 1.065, this cross is hovering in the lower range of the implied floor set by the SNB. Increased uncertainty caused by the upcoming European elections cycle will continue to test this floor, as the increased odds of an Eurosceptic government in France will not only decrease the value of the euro but will also put upward pressure on the franc, given its safe haven status. Nevertheless, the SNB will do everything in its power to weaken its currency as the Swiss economy continues to be plagued by deflationary forces: After showing glimpses of a recovery last month Real retail sales contracted by 3.5% YoY, falling well short of expectations. The SVMI Purchasing Manager's Index also came below expectations coming in at 54.6. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 USD/NOK has rebounded after reaching 8.20, its lowest level since Trump got elected. Interestingly, the NOK has not been as correlated with oil prices since the start of 2017 as it has been in the past. This is a trend worth monitoring. The inflation picture remains complex, although core and headline inflation have deaccelerated slightly as of late, inflation expectations are at their highest level of the last 9 years. Additionally house prices are growing at nearly 20%, a pace not seen since before the 2008 crisis. The Norges Bank is now facing a tough dilemma between risking an inflation overshoot if they keep their dovish bias or raising rates in an economy where growth for employment, real retail sales and nominal GDP is still in negative territory. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The SEK continues to duplicate the dollar's movements, rolling over slightly from the 7% appreciation it saw over a month and a half. A more accurate measure of the SEK's value, EUR/SEK, paints a similar picture. These movements have been more or less in line with the Riksbank's desired developments, as it indicates a deceleration in the pace of recent appreciation. However, we believe that the rebound in EUR/SEK is not likely to run further. Political turbulence is being priced into the euro. After sustaining near oversold levels, the rebound could be nothing more than momentum exiting from oversold territories. Nevertheless, it is likely that EUR/SEK will correct in the coming months due to European elections. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Fears that the Trump Administration will brow-beat America's trading partners into strengthening their currencies have pushed down the dollar in recent weeks. The likelihood of another Plaza-type accord remains extremely low, however. History suggests that such agreements only work when currency interventions are aligned with the underlying macroeconomic fundamentals. With the Fed eager to hike rates, that is not the case today. The only situation where a multilateral agreement to weaken the dollar could be reached is one where the dollar ascends so high that major financial stresses begin to form, particularly in emerging markets. We are not there yet. The real trade-weighted dollar is likely to rise 5%-to-10% by the end of the year. A stronger greenback will hurt U.S. corporate profit margins, allowing European and Japanese stocks to outperform in local-currency terms. Feature Dollar Under Pressure Chart 1The Recent Dollar Dip Is Not ##br##Reflected In Interest Rate Spreads After rallying sharply following the U.S. presidential election, the greenback has given up some of its gains. Since peaking in late December, the trade-weighted dollar has fallen by around 2.5%. Notably, the dollar's swoon has not been accompanied by a narrowing of 2-year real interest rate differentials between the U.S. and its trading partners (Chart 1). This suggests that shifts in relative growth expectations have played a relatively minor role during this latest dollar selloff. In our view, the more important factor has been the "weak dollar" rhetoric coming out of the Trump administration. Historically, U.S. officials have at least given lip service to America's "strong dollar policy." As with many other political customs, Trump has thrown this one out the window. Peter Navarro, head of Trump's National Trade Council, made headlines last week by calling Germany a "currency manipulator" - even though, strictly speaking, Germany does not have a currency to manipulate. This came on the heels of Trump's comments to The Wall Street Journal earlier in January where he lamented that "our currency is too strong... it's killing us." The President reiterated that sentiment last week, telling a group of pharmaceutical company executives: "You look at what China's doing, you look at what Japan has done over the years ... they play the devaluation market and we sit there like a bunch of dummies." A Deal That Worked The Trump administration's efforts to talk down the dollar have raised the question of whether another Plaza Accord is on the horizon. The original agreement was concluded at The Plaza Hotel in 1985. As fate would have it, Trump ended up buying the landmark property three years later. It would go on to be the setting for such historically momentous events as Trump's wedding to Marla Maples and his Oscar-worthy cameo in Home Alone 2: Lost In New York. The Plaza Accord prescribed that G5 nations - the U.S., Japan, Germany, the U.K., and France - intervene in currency markets with the aim of driving down the value of the dollar. At least in this respect, the Accord was a smashing success. Between early 1985 - when rumors of a deal began to swirl - and January 1987, the dollar fell by 54% against both the yen and the mark, 49% against the franc, and 44% against the pound. In fact, so effective was the Plaza Accord that it necessitated the Louvre Accord two years later, an agreement that was drawn up in order to halt the dollar's slide. Chart 2A Widening Current Account ##br##Deficit Sowed The Seeds For The Plaza Accord Then And Now: Some Similarities... There are some clear similarities between 1985 and the present. Just like today, the greenback strengthened significantly in the years leading up to the Accord. At first, the Reagan administration was content to let the dollar appreciate, seeing this as validation of its pro-growth policies. The Fed was also happy to go along with a stronger dollar since lower import prices helped to dampen inflation. As time wore on, however, the damage from an overvalued dollar became increasingly apparent: The current account balance swung from a modest surplus at the start of the 1980s to a deficit of 2.7% of GDP by the end of 1985 (Chart 2). The Big Three automakers, along with companies such as Caterpillar, IBM, and Motorola, began to lobby the U.S. government for trade sanctions against foreign competitors. With Reagan's appointment of James Baker to the post of Treasury Secretary in February 1985, U.S. trade policy moved away from being governed by a doctrinaire free market philosophy and took on a more pragmatic tone. Fearing further protectionist measures, the Japanese and Europeans agreed to take action to strengthen their currencies. ...But Some Notable Differences Despite the clear parallels between 1985 and the present, there are also a number of critical differences. First, there is the issue of magnitude. By early 1985, the greenback was entering the seventh year of a massive bull market - one that had lifted the real broad trade-weighted dollar up 53% from its lows in October 1978 (Chart 3). In contrast, the current dollar bull market is a mere 2.5 years old and has seen the dollar strengthen by "only" 20% since July 2014. Moreover, the current bull market began from a point where the dollar was highly undervalued. As a consequence, as of today, the real trade-weighted dollar remains 21% below its 1985 peak and 11% below its 2002 peak. Second, one of the reasons the Plaza Accord worked so well was because policymakers ensured that their currency interventions were consistent with the macroeconomic fundamentals. The combination of tight monetary policy and loose fiscal policy created a fertile backdrop for the dollar's ascent in the early 1980s. By 1984, however, those bullish dollar fundamentals started to break down. Chart 4 shows that the dollar continued to appreciate into 1985, even though U.S. interest rates were declining relative to other G5 economies. The dollar, in other words, had entered a full-fledged bubble - one that was ripe for a pricking. Chart 3The Dollar Is ##br##Below Past Peaks Chart 4A Full-Fledged Dollar ##br##Bubble Preceded The Plaza Accord Once the dollar bubble burst, monetary policy amplified the downward pressure on the greenback. Most notably, the Federal Reserve continued cutting interest rates, ultimately taking the effective Fed funds rate down from 11.8% in July 1984 to 5.8% in October 1986. As a result, the 2-year nominal interest rate differential shrank by 454 basis points against Japan over this period. For the U.K., the interest rate differential fell by 630 basis points, while for Germany it declined by 407 basis points. In contrast to the mid-1980s, the Fed is unlikely to lean into dollar weakness this time around. The output gap in the U.S. has been nearly eliminated and the economy continues to grow at an above-trend pace. This suggests that the Federal Reserve will keep raising rates. We expect the Fed to hike rates three times this year, one more than the market is pricing in. Most other central banks are nowhere near the point where they can start tightening monetary policy. As such, the interest rate differential between the U.S. and its trading partners is likely to widen further. In a world where foreign exchange trading now exceeds $5 trillion per day, any currency intervention - unless it is backed by an underlying shift in the economic fundamentals - is bound to backfire. A Political Reality Check Chart 5China's Weight Matters Political considerations also render another Plaza Accord highly improbable. In the 1980s, West Germany and Japan were politically subservient to the U.S. That is less the case today. China's role in the global economy has also expanded. The RMB now accounts for 22% of the Fed's broad trade-weighted dollar basket, the largest weight of any country (Chart 5). China's government will fiercely resist negotiating any agreement that is not in the country's best interests. The economic circumstances facing most of America's trading partners could also scuttle any hopes for a deal to weaken the dollar. Inflation expectations in Japan have risen over the past six months, but still remain well below the BoJ's 2% target. A stronger yen would undermine efforts to reflate the economy. The German economy is certainly benefiting from an undervalued exchange rate. However, a continued weak currency is necessary for Southern Europe, where unemployment is still very high. Moreover, it is not clear that Germany could stomach a much stronger euro. The German unemployment rate is at a 25-year low, but that is because the country is running a massive 9% of GDP current account surplus. Take away Germany's ability to export its excess savings abroad, and the German economy would look a lot like Japan's. The only scenario in which a new multilateral accord would be seriously entertained is if a rising dollar began to wreak havoc on the global economy. A modestly stronger dollar would boost global growth to the extent that it redistributed demand from the U.S. to economies such as Europe and Japan with greater levels of economic slack. However, if the greenback were to ascend into bubble territory, this could instigate a vicious circle where an appreciating dollar increases the local-currency value of EM dollar-denominated debt, leading to a wave of bankruptcies and defaults, and, in the process, generating even further selling pressure on EM currencies. That said, the dollar would probably need to appreciate by another 15% or so before a crisis occurred. And even if a meltdown seemed imminent, the bar for currency intervention would remain quite high. No emerging market wants to go cap-in-hand to the IMF or the U.S. Treasury. This is particularly true for China, which would likely shun any offers of assistance, even if capital were flooding out of the country. In any case, if a deal were reached, it would likely seek to prevent the dollar from rising further, rather than falling in value. That is a critical distinction. Trump, Trade, And The Fed The discussion above suggests that a new Plaza-style accord is not in the cards, at least not unless the dollar strengthens substantially from current levels. Where does that leave Trump's pledge to bring manufacturing jobs back to the U.S.? We see two possible ways that Trump could try to square this circle. First, Trump could lean on the Fed to maintain a highly accommodative monetary stance. Since inflation expectations are likely to rise further as the economy begins to overheat, it is possible that real rates would actually decline unless the Fed raised rates fast enough, pushing down the dollar in the process. The problem with this theory is that Trump's public pronouncements on monetary policy have generally been on the hawkish side. He criticized Janet Yellen on the campaign trail, accusing her of trying to goose the economy in order to help the Democrats at the polls. Granted, Trump's views on the hard money/easy money debate may have changed now that he is President and poised to benefit politically from a more stimulative monetary policy. Nevertheless, it will be difficult for him to make a complete U-turn on the subject, especially since Congressional Republicans are likely to resist efforts to pack the FOMC with doves. As long as the economy is doing well, our guess is that Trump will accede to Republican demands that he nominate members to the FOMC with a somewhat hawkish disposition. This should keep the dollar uptrend intact. If a policy U-turn does occur, it will happen towards the end of the decade, by which time the economy will be due for another recession. With another presidential election looming at that point, Trump might end up taking a page out of the old Nixon playbook and browbeat the Fed chair into pursuing a massively expansionary monetary policy.1 This could set the stage for a stagflationary episode, a prediction we discussed at length in our latest Strategy Outlook.2 In the meantime, Trump will try to mitigate the effects of a stronger dollar on U.S. manufacturing by pursuing a more protectionist trade agenda. This is likely to entail expanding the use of countervailing duties which target foreign industries that are alleged to be engaging in unfair trade practices - similar to what Obama did when he slapped an extra 35% duty onto Chinese tires in 2009. Trump is also likely to continue "twitter shaming" companies that have moved, or are contemplating moving, production abroad. On the whole, however, a radical departure from existing trade policy is unlikely as long as the economy continues to expand. Nevertheless, as with his approach to Fed policy, Trump could break with all established traditions if unemployment starts rising and his poll numbers begin tumbling. In other words, a major trade war is coming, just not yet. Investment Conclusions Chart 6The Dollar Can Climb Amid ##br##Bullish Sentiment In politics, as in life, preferences are not the only things that matter. Constraints are as important, if not more so. Just as in the early 1980s, the U.S. is pursing a policy of fiscal easing and monetary tightening. As was the case back then, this has led to a stronger dollar. It would be easy to say that Trump could badger other countries into tightening monetary policy in order to keep the dollar from appreciating. Even if we ignore the political implausibility of such a strategy, it still would not work. If a country needs a low interest rate to keep growth from stalling, then raising rates is unlikely to boost that country's currency. The market will realize in short order that the central bank will eventually have to reverse course and cut rates to keep deflationary forces from setting in. The point is that trying to influence exchange rates without changing the economic fundamentals is destined to fail. We expect the real trade-weighted dollar to rise 5%-to-10% by the end of the year. Granted, bullish dollar sentiment is widespread these days (Chart 6). However, dollar bulls were around in even greater numbers in the second half of the 1990s, and this did not prevent the greenback from scaling to new highs. If the dollar resumes its ascent, as we expect, this could hurt U.S. corporate profit margins, allowing European and Japanese stocks to outperform in local-currency terms. A stronger greenback would also weigh on commodity prices, with metals being the most vulnerable. The risks to our dollar view are fairly symmetric. On the downside, the failure of the Trump administration to loosen fiscal policy could prevent the Fed from hiking rates as much as planned. The risk here is not so much that the tax cuts will be scuttled, but rather that Congressional Republicans succeed in pushing through big spending cuts as part of any budget deal. On the upside, the passage of a Border Adjustment Tax - something to which we assign 50% odds - would lift the dollar.3 Rising stress in emerging markets could also push money into safe haven markets such as U.S. Treasurys, similar to what happened during the late 1990s. This could cause the dollar to appreciate more than our baseline forecast implies. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 Burton A. Abrams, "How Richard Nixon Pressured Arthur Burns: Evidence From The Nixon Tapes," The Journal of Economic Perspectives, Vol. 20, no. 4 (2006), pp.177-188. 2 Please see Global Investment Strategy, "Strategy Outlook First Quarter 2017: From Reflation To Stagflation," dated January 6, 2017, available at gis.bcaresearch.com. 3 Please see Global Investment Strategy Special Report, "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017," dated January 20, 2017, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades