Currencies

Dear clients, In addition to this short weekly report, you will also receive a Special Report penned by my colleague Jonathan LaBerge on Sweden, with implications for the SEK. I hope you will find the report both useful and insightful. In the interim, I wish safety for you and your families. Best Regards, Chester Ntonifor Highlights The lack of dollar liquidity had been a tailwind behind the dollar bull market. However, an expansion in the Federal Reserve’s balance sheet should help stem the global shortage of dollars. Ditto if there is an expansion of swap lines beyond the five major central banks. The risk is that the shortage of dollars has already begun to trigger negative feedback loops in a few countries. Until tentative signs emerge that the global economy is on better footing, expect spikes in the dollar. The caveat is that a big fiscal spending package in the US should lead to a deterioration in the current account. This will improve the offshore dollar liquidity situation. Feature The latest flare-up in risk aversion has also rotated to the offshore dollar funding market. Across G10 countries, US dollar cross-currency basis swaps - a measure of the costs to obtain greenbacks domestically - have been rising at an alarming pace. During the Federal Reserve’s emergency meeting on Sunday, swap lines were extended to five major central banks. The terms were very generous, with costs at the overnight index swap rate + 25 basis points, as well as a maturity of 84 days. However, the following day, the dollar continued its fervent rally, with the euro-US cross-currency basis swap touching -120 points (Chart 1). Chart 1A Broad-Based Funding Crisis The lack of follow through from the Fed’s liquidity injection highlights a fundamental risk to our sanguine view that the dollar should top out sooner rather than later. While we maintain this view, it has been discouraging that the DXY has broken above 100. We had anticipated a move higher on February 21, prompting us to close our long DXY position for a loss. Today, we suggest waiting for better signposts to short the greenback outright.1 US Dollar Flows The dollar remains the reserve currency of today, with the Fed at the center of the global financial architecture. The process behind dollar shortages is a simple one: Chart 2Global FX Reserve Growth Was Anemic Countries that are experiencing falling trade balances (because of a trade slowdown or trade war) will see a fall in their foreign exchange reserves. This naturally means that their supply of dollars is declining (Chart 2). Wary of seeing local dollar interest rates rise (leading to a higher dollar, and some companies going bust), central banks could sell dollars to the private sector in exchange for local currency. As a reserve currency, the US trade deficit is also settled in dollars. This naturally leads to a flow of greenbacks outside US borders. However, it also means that the current account deficit finances the budget deficit. Therefore, a falling trade surplus in exporting countries naturally means a falling deficit in the US. In order to stimulate the US economy, the authorities pursue macroeconomic policies that tend to weaken the dollar, such as lowering rates and/or running a wider fiscal deficit. The central bank helps finance this fiscal deficit via expanding the monetary base (Seigniorage). The drop in rates causes the yield curve to steepen. This incentivizes banks to lend, which in turn boosts US money supply. As the economy recovers and demand for imports (machinery, commodities, consumer goods) rises, the current account deficit widens. This leads to a renewed outflow of dollars. It is easy to see where the process can get short-circuited, especially via an external shock. If you accept the premise that the sum of the Fed’s custody holdings together with the US monetary base constitutes the root of global dollar liquidity, then it is not yet accelerating fast enough.2 Like in the past, the Fed has been quick to correct the situation: Recently, it has instituted swap lines. However, they remain inadequate for three key reasons: The swap lines should be extended from the five central banks to many countries, because Covid-19 is now a global pandemic. Not even China (along with other emerging markets) was  included in the swap agreements. The swap lines usually have terms/limits/amounts, which means that even if the domestic central bank decided to be the lender of last resort, it could still run short of dollars. Widespread fiscal measures have been announced, but this has been mostly geared towards sustaining income. Until governments unilaterally backstop airlines, shipping firms, restaurants, or any other company afflicted by the virus from going bankrupt, a negative self-reinforcing feedback loop will remain. Chart 3The Dollar As An Arbiter Of Growth We continue to recommend standing aside on the dollar until the dust has settled. Longer-term fundamentals suggest a dollar-bearish view, but until the world gets a sense that global growth is bottoming soon, the dollar uptrend remains intact (Chart 3). We continue to use internals and market fundamentals as a guide for when to time a top.3  Finally, we have been stopped out of a few trades and are tightening stops on a few. Please see this week’s trade table for a few recommendations.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com     Footnotes 1    Please see Foreign Exchange Strategy Weekly Report,  “The Near-Term Bull Case For The Dollar”, dated February 28, 2020, available at fes.bcaresearch.com. 2   Please see Foreign Exchange Strategy Weekly Report,  “Is The World Short Of Dollars?”, dated September 13, 2019, available at fes.bcaresearch.com. 3   Please see Foreign Exchange Strategy Weekly Report,  “Currency Technicals And Market Internals”, dated March 13, 2020, available at fes.bcaresearch.com. Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Special Report

Highlights Since 2004, Sweden’s private sector leverage trend can be explained using a simple Taylor rule approach. The approach clearly highlights three distinct monetary policy phases, and underscores the singular role of inflation (not systemic risk from rising indebtedness) as a driving factor for Riksbank policy. Since 2015, the Riksbank has maintained interest rates well below what a Taylor rule approach would suggest, owing to the desire to raise inflation expectations and Sweden’s high trade exposure to the euro area. This highlights strong similarities between the experience of Sweden and Canada: both countries are in the orbit of a major neighboring central bank, which has created serious distortions in both economies. Given the extent of the spread of the SARS-CoV-2 virus, especially in Europe, our assessment of the Riksbank’s reaction function suggests the odds appear to be high that the repo rate will move back into negative territory at some point this year (despite their reluctance to do so). Over the near-term, Swedish policy easing suggests that investors should avoid the krona versus both the US dollar and euro. Over a medium-term time horizon, one implication of a return to negative interest rates is that Swedish house price appreciation is likely to trend higher once the economic impact of the COVID-19 pandemic ends, potentially to the benefit of Swedish consumer durable and apparel stocks. Finally, over the long-term, Sweden is very likely to face a period of domestic economic stagnation stemming from the extraordinary rise in private sector debt that has built up over the past two decades. The co-ordinated global response to the pandemic suggests that this is not the end of Sweden’s debt supercycle, but timing the transition from reflation to stagnation will be of crucial importance for investors exposed to the domestic Swedish economy over the coming few years. Feature One of the worrying legacies of the global financial crisis has been a substantial buildup in private sector debt in many economies around the world. This has most famously occurred in China, but private indebtedness is also very high in many developed economies. Among advanced countries, Sweden stands out as being particularly exposed to elevated private sector debt. Chart I-1 highlights that Sweden’s private sector debt-to-GDP ratio has ballooned to a massive 250% of GDP over the past 15 years, from a starting point of roughly average indebtedness. Chart I-1Sweden's Extremely Indebted Private Sector In this report we explore why Sweden has seen an explosion in private sector debt-to-GDP, and highlight that Sweden’s experience can be compared closely with that of Canada – both countries are in the orbit of a major neighboring central bank, which has created distortions in each economy. We also summarize what this implies for Riksbank policy, and what investment recommendations can be drawn from our analysis. We conclude that while the Riksbank is clearly reluctant to cut the repo rate after having just existed its negative interest rate position last year, it appears likely that they will forced to do so unless the negative economic impact from the COVID-19 pandemic abates very soon. Over the short-term, this suggests that investors should avoid the Swedish krona, versus either the US dollar or the euro. Why has Sweden seen such an explosion in private-sector debt? Over the medium-term, easy Riksbank policy and the probable absence of any additional macroprudential measures is likely to spur a renewed increase in Swedish house prices and household debt, which will likely benefit consumer durables and apparel stocks relative to the broad Swedish equity market.  But this will reinforce Sweden’s existing credit bubble, and similar to Canada will set the stage for domestic economic stagnation over the very long-term. Riksbank Policy and Sweden’s Private Sector Debt: A Tale Of Three Phases Much of the investor attention on Sweden's extremely high private sector debt load has occurred following the global financial crisis. But Chart I-1 clearly highlights that the process of private sector leveraging began in 2004, arguing that the Riksbank’s easy monetary policy stance following the global financial crisis is not the only cause of Sweden’s extremely elevated private debt-to-GDP ratio. In a previous Special Report for our Global Investment Strategy service,1 we investigated a similar experience in Canada and used a simple Taylor rule approach to show that the Bank of Canada’s decision to maintain interest rates below equilibrium levels for nearly two decades has contributed to a substantial buildup in private sector leverage. A similar approach for Sweden highlights similar conclusions, albeit with some complications: Chart I-2 shows our Taylor rule estimate for Sweden alongside the policy rate, and shows the deviation from the rule in the second panel. Chart I-2Since 2000, Sweden Has Had Three Distinct Monetary Policy Phases Compared with Canada’s experience, which has maintained too-low interest rates consistently for the past 20 years, Chart I-2 shows that the stance of Sweden’s monetary policy since 2000 falls into three distinct phases: Persistently easy policy from 2000 to 2008 A period of less easy and then relatively tight policy from 2009 to early-2014 A period of extremely easy policy from 2015 until today. The first phase noted above closely resembles the experience of Canada: policymakers in both countries simply kept interest rates too low during the last global economic expansion. In the second phase, the stance of monetary policy in Sweden became progressively less easy: the Taylor rule collapsed in 2009/2010, and trended lower again during the euro area sovereign debt crisis as well as its aftermath. In fact, Chart I-2 suggests that Sweden’s monetary policy stance was outrightly tight from 2012-2014, and in early-2014 the Taylor rule recommended negative policy rates while the actual policy rate was above 1%. In the third phase, the Riksbank appears to have overcompensated for the second phase of relatively less easy and eventually tight monetary policy. The Riksbank pushed policy rates into negative territory in late-2014, as had been recommended by the Taylor rule a year before, at a time when the rule was rising sharply. Roughly 2/3rds of the rise in the rule from early-2014 to late-2018 occurred due to the significant rise in Swedish inflation, with the rest due to a rise in Sweden’s output gap – which turned positive in late-2016 according to the OECD (Chart I-3). It is this third phase, featuring a massive and glaring gap between Swedish policy rates and a monetary policy rule that correctly recommended easy policy from 2010 – 2014, that has attracted global investor attention over the past few years. But Chart I-4 presents Sweden’s Taylor rule gap alongside its private sector debt-to-GDP ratio, and highlights that over 80% of the rise in the latter since 2000 actually occurred in the first phase described above – a period of persistently easy monetary policy as defined by our Taylor rule approach. The behavior of Sweden’s private sector debt-to-GDP ratio in the second and third phases also seems to validate our approach, as gearing essentially stopped during the second phase and restarted in the third phase. Chart I-3Since 2014, Sweden’s Rising Taylor Rule Has Been Driven Mostly By Inflation Chart I-4Sweden’s Monetary Policy Phases Explain Its Private Sector Leveraging The Riksbank: “Talk To Us About Inflation, Not Debt” Chart I-5During Phase 2, Households Clearly Took Advantage Of Low Mortgage Rates It is crucial to understand the motivations of Sweden’s central bank during each of these phases in order to be able to forecast the likelihood of a return to negative interest rates this year, as well as the Riksbank’s likely policy response once the COVID-19 pandemic subsides. In the first monetary policy phase that we have described, Sweden was not the only country to maintain persistently easy monetary policy. Given the relative scarcity of private sector deleveraging events in the post-war era, most policy makers, academic economists, and market participants were regrettably unconcerned about rising private sector indebtedness during this period, and only came to understand the consequences during the crisis and its aftermath. Most advanced economies leveraged during the first of Sweden’s monetary policy phases, and Sweden really only stands out as a major outlier from 2007 – 2009 when nearly 60% of the country’s total 2000-2019 private sector leveraging occurred (most of which, in turn, occurred before the collapse of Lehman Brothers in September 2008). In essence, by the time that Swedish policymakers were given a vivid and painful demonstration of the dangers of elevated private sector debt, it was too late to prevent most of the increase in debt-to-GDP that is facing the country today. In the second phase of Sweden's modern monetary policy, our Taylor rule framework highlights that the Riksbank largely acted as appropriate. One complication, however, is the difference in the leverage trend between Sweden's nonfinancial corporate and household sectors. Chart I-5 clearly highlights that Sweden's household sector took advantage of low interest rates during the country’s second monetary policy phase. Household sector leveraging began to rise again starting in late-2011, whereas it was completely absent for the corporate sector during the period. A crucial reason why the Riksbank ignored this renewed household sector leveraging is also part of the reason that it has maintained extremely low policy rates in the third phase noted above. The Riksbank’s monetary policy strategy, which is published in every monetary policy report, includes the following: “According to the Sveriges Riksbank Act, the Riksbank’s tasks also include promoting a safe and efficient payment system. Risks linked to developments in the financial markets are taken into account in the monetary decisions. With regard to preventing an unbalanced development of asset prices and indebtedness however, well-functioning regulation and effective supervision play a central role. Monetary policy only acts as a compliment to these.” In other words, the Riksbank has been very clear that preventing excessive leveraging is not its responsibility, and that the job ultimately falls to the Swedish government. But if the Taylor rule was recommending meaningfully higher interest rates during phase 3, then why did the Riksbank continue to lower interest rates into negative territory until last year? In our view, their behavior can be explained by the confluence of three factors: 1. Sweden’s deflation scare in 2014: Sweden’s underlying inflation rate had been trending lower for four years by the time that it dipped briefly into negative territory in March 2014. By this point, the Riksbank appears to have become increasingly concerned about inflation expectations rather than the trend in actual inflation. Chart I-6 presents Sweden’s underlying inflation rate and an adaptive-expectations based estimate of inflation expectations alongside the repo rate, and shows that inflection points in the repo rate match inflection points in expectations. Specifically, the repo rate continued to fall until inflation expectations stabilized in early-2016, and the Riksbank did not raise the repo rate until expectations crossed above 1.5%, a level that was reasonably close to the central bank’s 2% target. Chart I-6During Phase 3, The Riksbank Focused On Low Inflation Expectations 2. Sweden’s high trade sensitivity: Chart I-7 highlights that Sweden’s economy, like Canada and other Scandinavian countries, is highly exposed to exports to top trading partners. The euro area accounts for a large portion of Sweden’s exports, and Chart I-8 highlights that nominal euro area imports from Sweden remained very weak from 2012-2016. In addition, Sweden’s import sensitivity is also very high, with total imports of goods and services accounting for over 40% of Sweden’s GDP. By our calculations, roughly 2/3rds of Swedish imports are for domestic consumption,2 and Chart I-9 highlights how closely (inversely) correlated imported consumer and capital goods prices are to Sweden’s trade-weighted currency index. By pushing the repo rate into negative territory, the Riksbank reinforced rising inflation expectations by supporting exports and importing inflation from its trading partners via a weaker krona. Chart I-7Sweden, Like Other Small DM Countries, Are Highly Exposed To Trade Chart I-8Euro Area Demand For Swedish Goods Remained Weak For Several Years Chart I-9To 'Import' Inflation, The Riksbank Had To Weaken The Krona 3. The euro area’s persistently weak inflation and extremely easy monetary policy: While this is related to Sweden's overall trade sensitivity, the fact that the euro area had to combat persistently weak inflation with negative interest rates and asset purchases from late-2014 to late-2018 has had a particularly strong impact on Riksbank policy given the latter’s goal of boosting Swedish inflation via higher import prices. Chart I-10 highlights the strong link between the SEK-EUR exchange rate and the real interest rate differential between the two countries, and in particular shows that the Riksbank had to lower the differential into negative territory in order to bring the krona below “normal” levels (defined here as the average of the past global economic expansion). When faced with a real euro area policy rate of roughly -1.5% during the period (Chart I-11), the only way to achieve a negative real rate differential was to maintain the repo rate at an extremely low level as Swedish inflation rose. Chart I-10To Weaken The ##br##Krona... Chart I-11…Deeply Negative Real Policy Rates Were Required Where Next For The Repo Rate? In February 2019 the Riksbank was forecasting that the repo rate would return into positive territory by the end of this year, and would rise as high as 80 basis points by mid-2022. They downgraded this assessment in April, and again in October, highlighting that they expected a 0% repo rate for essentially the entire three-year forecast period. In other words, the Riksbank had been moving in a dovish direction even before the COVID-19 pandemic began. Prior to the outbreak, we would have been inclined to argue that the Riksbank’s forecast of a 0% repo rate beyond 2020 was suspect, given the budding recovery in global growth. Chart I-12 highlights that the global PMI had been improving for several months prior to the outbreak, and the Swedish PMI and consumer confidence index had recently rebounded sharply. A negative repo rate was essential to “import” inflation. But, given the extent of the spread of the SARS-CoV-2 virus, especially in Europe, and our description of the Riksbank mandate and reaction function, the odds appear to be high that the repo rate will move back into negative territory at some point this year. Besides the very negative direct impact to global trade from the pandemic, Chart I-13 highlights that Swedish inflation is now falling, and that our measure of inflation expectations has now peaked. Chart I-12Swedish Economic Momentum Was Building Prior To The Pandemic... Char I-13...But Inflation Is Falling And The Unemployment Rate Is Rising In addition, the Swedish unemployment rate has been trending higher since early-2018 (Chart I-13, second panel), in response to several factors: a shock to household wealth in late-2015/early-2016 due to sharply falling equity prices, a meaningful decline in house prices driven by newly introduced macroprudential policies, and a sharp albeit seemingly one-off decline in the contribution to Swedish economic growth from government expenditure (Chart I-14). These trends would have likely reversed at some point this year given the building economic momentum that was evident in January and early-February, but it is now clear that the pandemic will more than offset the budding improvement in economic activity. Chart I-14Swedish Policymakers Will Have To Reverse The Factors That Caused The Pre-Pandemic Slowdow Over the past week the Riksbank has announced two policies: it will provide cheap loans to the country’s banks (500 billion SEK) to bolster credit supply to Swedish small & medium-sized enterprises, and it will increase its asset purchase program by 300 billion SEK. The Riksbank is clearly reluctant to cut the repo rate after having just existed its negative interest rate position last year, and has argued that strong liquidity support and stepped up asset purchases are more likely to be effective measures in the current environment. However, Charts I-10 & I-11 underscored the link between real interest rate differentials and the currency, and the Riksbank will risk having the krona appreciate versus the euro and other currencies if inflation continues to fall and the policy rate is kept unchanged. Chart I-15 shows that market participants have already begun to price in cuts to the repo rate, and our sense is that the Riksbank will be forced to act in a way that is consistent with the market’s view. Chart I-15The Market Expects The Riksbank To Return To Negative Interest Rates. We Agree. Investment Conclusions Over a cyclical (i.e. 6-12 month) time horizon, the Swedish krona is the asset with the clearest link to our discussion of Riksbank policy, and investors should recognize that the krona call is now a binary one based on the evolution of the COVID-19 pandemic. It is one of the cheapest currencies in the G10 space, but foreign exchange markets have recently ignored fundamentals such as interest rate differentials and valuation. This is particularly true in the face of a spike in US dollar cross-currency basis swaps, which have started to send the dollar higher even against the safe haven currencies. In such an a environment, selling pressure could continue to push SEK lower, especially if the Riksbank is pushed to reduce the repo rate sooner rather than later. The SEK is one of the most procyclical currencies in the FX space, suggesting that investors should stand aside until markets stabilize (Chart I-16). Right now, the Swedish krona is the clearest play on Riksbank policy. As for the EUR/SEK cross, any renewed ECB stimulus suggests that Sweden will act accordingly to prevent the SEK from appreciating too far, too fast. EUR/SEK will top out after global growth is in an eventual upswing, and the Riskbank has eased policy further. Over the medium-term time horizon, one implication of a return to negative interest rates is that Swedish house price appreciation is likely to trend higher once the economic impact of the COVID-19 pandemic ends. House prices will likely decelerate in the near term given the shock to household wealth from falling equity prices, but we showed in Chart I-5 that Sweden’s household sector ultimately took advantage of low interest rates during Sweden’s second monetary policy phase. We expect a similar dynamic to unfold beyond the coming 6-9 months, and Chart I-17 highlights that overweighting Swedish consumer durable and apparel stocks within the overall Swedish equity market is likely the best way to eventually play a resumption of household leveraging and rising house prices. Chart I-16Avoid Krona Exposure ##br##For Now Chart I-17Swedish Consumer Durables & Apparel Stocks Linked To Domestic, Not Global, Demand With the exception of a selloff in 2013, the relative performance of the industry group has closely correlated with house price appreciation, and is now deeply oversold. The companies included the industry group earn a significant portion of their revenue from global sales, but the close correlation of relative performance with Swedish house prices and limited correlation with the global PMI suggests that domestic economic performance matter in driving returns for these stocks (Chart I-17, bottom panel). We are not yet prepared to recommend a long relative position favoring this industry group, but we are likely to view signs of policy traction and a relative performance breakout as a good entry point. Finally, the key long-term implication of our research is that Sweden will at some point likely face a period of stagnation stemming from the extraordinary rise in private sector debt that has built up over the past two decades. While regulators had begun to combat excessive debt with macroprudential measures, further measures to restrict household sector debt are extremely unlikely to occur until after another substantial reacceleration in Swedish house prices and another nontrivial rise in household sector leverage. This will be cyclically positive for Sweden coming out of the pandemic, but will ultimately make Sweden’s underlying debt problem meaningfully worse. Macroprudential control of rising nonfinancial corporate debt has not and is not likely to occur, and no regulatory control measure will be able to significantly ease the existing debt burden facing the private sector. Chart I-18 highlights that while Sweden’s private sector debt service ratio (DSR) is not the highest in the world, is it extremely elevated compared to other important DM countries such as the US, UK, Japan, and core euro area. Several other countries with higher private sector DSRs, such as Canada and Hong Kong, are also at serious risk of long-term stagnation. Chart I-18Swedish Domestic Economic Stagnation Is A 'When', Not An 'If' We have not yet identified a specific list of assets that will be negatively impacted by Swedish domestic economic stagnation over the longer term. Our European Investment Strategy service recently argued that Swedish stocks are attractive over the very long term versus Swedish bonds, based on valuations and the fact that the Swedish equity market as a whole is heavily driven by the global business cycle. We plan on revisiting the question of which equity sectors are most vulnerable to domestic stagnation in a future report, as the onset of stagnation draws nearer. As we noted in our report on Canada,3 it is difficult to identify precisely when Sweden’s high debt load will meaningfully and sustainably impact Swedish economic activity and related equity sectors. The acute shock to global activity from the COVID-19 pandemic is an obvious potential trigger, but the fact that policymakers around the world are responding forcefully to the pandemic suggests that this is not the end of Sweden’s debt supercycle. In this regard, the prospect of globally co-ordinated fiscal spending is especially significant. Our best guess is that Sweden’s true reckoning will come once US and global activity contracts for conventional reasons, instigated by tight monetary policy to control rising and above-target inflation. This may mean that Sweden will avoid a balance sheet recession for some time, but investors exposed to domestically-linked Swedish financial assets should take heed that the eventual consequences of such an event are likely to grow in magnitude the longer it takes to arrive. In short, beyond the acute nearer-term impact of the pandemic, Sweden is likely to experience short-term gain for long-term pain. The short- to medium-term focus of investors should be on the former, but with full recognition that the latter will eventually occur. Timing the transition between these two states will be of crucial importance for investors exposed to the domestic Swedish economy over the coming few years. Stay tuned!   Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Footnotes 1 Please see Global Investment Strategy Special Report "Canada: A (Probably) Happy Moment In An Otherwise Sad Story," dated July 14, 2017, available at uses.bcaresearch.com 2 We assume that all services imports are consumed domestically. Among goods exports, we assume domestic consumption of all imports of food & live animals, beverages & tobacco, mineral fuels, lubricants, and related materials, miscellaneous manufactured articles, road vehicles, and other goods. 3 Please see Global Investment Strategy Special Report "Canada: A (Probably) Happy Moment In An Otherwise Sad Story," dated July 14, 2017, available at uses.bcaresearch.com

Highlights Our short EM equity index recommendation has reached our target and we are booking profits on this trade. The halt to economic activity will produce a global recession that will be worse than the one that took place in late 2008. We continue to recommend short positions in a basket of EM currencies versus the US dollar. In EM fixed-income markets, the duration of the ongoing selloff has been short, and large losses will trigger more outflows ensuring further carnage. Stay defensive for now. Russia is unlikely to make a deal with Saudi Arabia to restrain oil output for now. Feature The global economy is experiencing a sudden, jarring halt. The only comparison for such a sudden stop is the one that occurred in the fall of 2008, following Lehman’s bankruptcy. In our opinion, the global economic impact of the current sudden stop is shaping up to be worse than the one that occurred in 2008. That said, we are taking profits on our short position in EM equities. This position – recommended on January 30, 2020 – has produced a 30% gain.   EM share prices have reached the long-term support that acted as the ultimate floor during the bear markets in 1997-‘98, 2001-‘02, 2007-‘08 and 2015. Our decision to take profits reflects investment discipline. The MSCI EM stock index in US dollar terms has reached our target. In addition, this decision is consistent with two important indicators that we follow and respect: 1. EM stocks have become meaningfully cheap. Chart I-1 illustrates that our cyclically-adjusted P/E (CAPE) ratio for EM equities is about one standard deviation below its fair value – the same level when the EM equity market bottomed in 1998, 2008 and 2015. Chart I-1EM Equities Are Cheap According To The Cyclically-Adjusted P/E Ratio For this EM CAPE ratio to reach 1.5 standard deviations below its fair value – the level that is consistent with EM’s 2001-02 lows – EM share prices need to drop another 15%. 2. In term of the next technical support, EM share prices have reached the long-term support that acted as the ultimate floor during the bear markets in 1997-‘98, 2001-‘02, 2007-‘08 and 2015 (Chart I-2). Chart I-2EM Share Prices Are At Their Long-Term Support While share prices are likely to undershoot, it is risky to bet on a further decline amid current extremely elevated uncertainty and market volatility. The Global Downturn Will Be Worse Than In Late 2008 Odds are that the current global downturn is shaping up to be worse than the one that occurred in late 2008. From a global business cycle perspective, the current sudden halt is beginning from a weaker starting point. Global trade growth was positive back in August-September 2008 – just prior to the Lehman bankruptcy – despite the ongoing US recession (Chart I-3A). In comparison, global trade was shrinking in December 2019, before the COVID-19 outbreak (Chart I-3B). Chart I-3AGlobal Trade Growth Was Positive In September 2008… Chart I-3B…But Was Negative In December 2019   This is because growth in EM and Chinese economies was still very robust in the middle of 2008. Moreover, the economies of EM and China were structurally very healthy and were anchored by solid fundamentals. Still, the blow to confidence emanating from the crash in global financial markets and plunge in US domestic demand in the fall of 2008 produced major shockwaves in EM/Chinese financial markets. Provided the ongoing negative confidence shock and lingering uncertainty persist, odds are that the risk premium will initially overshoot before settling down. Consistently, risk markets will undershoot in the interim. This is in contrast with current cyclical growth conditions and structural economic health, both of which are very poor in EM/China going into this sudden stop.   In China, economic growth in January-February 2020 was much worse than at the trough of the Lehman crisis in the fourth quarter of 2008. Chart I-4 reveals that industrial production, auto sales and retail sales volumes all contracted in January-February 2020 from a year ago. The same variables held up much better in the fourth quarter of 2008 (Chart I-4). Business activity in China is recovering in March, but from very low levels. Reports and evidence from the ground suggest that many companies are operating well below their ordinary capacity – the level of economic activity remains well below March 2019 levels. US real GDP, consumer spending and capital expenditure shrunk by 4%, 2.5% and 17% at the trough of 2008 recession (Chart I-5). Odds are that these variables will plunge by an even greater magnitude in the coming months as the US reinforces lockdowns and public health safety measures. Chart I-4China Business Cycle Was Much Stronger In Q4 2008 Than Now Chart I-5US Growth At Trough Of 2008 Recession   Chart I-6US Small Caps: Overlay Of 2008 And 2020 About 50% of consumer spending in the US is attributed to people over 55 years of age. Provided COVID-19’s fatality rate is high among the elderly, odds are this cohort will not risk going out and spending. How bad will domestic demand in the US be? It is impossible to forecast with any certainty, but our sense is that it will plunge by more than it did in the late 2008-early-2009 period, i.e., by more than 4% (Chart I-5, bottom panel). Interestingly, the crash in US small-cap stocks resembles the one that occurred in the wake of the Lehman bankruptcy (Chart I-6). If US small-cap stocks follow their Q4 2008 - Q1 2009 trajectory, potential declines from current levels will be in the 10%-18% range. Bottom Line: The current halt in economic activity and impending global recession will be worse than the one that took place in late 2008. Reasons Not To Jump Into The Water…Yet Even though EM equities have become cheap and oversold and we are booking profits on our short position in EM stocks, conditions for a sustainable rally do not exist yet: So long as EM corporate US dollar bond yields are rising, EM share prices will remain under selling pressure (Chart I-7). Corporate bond yields are shown inverted in this chart. Chart I-7EM Stocks Fall When EM Corporate Bond Yields Rise Chart I-8Chinese And Emerging Asian Corporate Bond Yields Are Spiking The selloff in both global and EM credit markets began only a few weeks ago from very overbought levels. Many investors have probably not yet trimmed their positions. Hence, EM sovereign and corporate credit spreads and yields will likely rise further as liquidation in the global and EM credit markets persists. Consistently, bond yields for Chinese offshore corporates as well as emerging Asian high-yield and investment-grade corporates are rising (Chart I-8). EM local currency bond yields have also spiked recently as rapidly depreciating EM currencies have triggered an exodus of foreign investors. Rising local currency bond yields are not conducive for EM share prices (Chart I-9). Chart I-9EM Equities Drop When EM Local Bond Yields Rise EM ex-China currencies correlate with commodities prices (Chart I-10). Both industrial commodities and oil prices have broken down and have further downside. The path of least resistance for oil prices is down, given anemic global demand and our expectation that Russia and Saudi Arabia will not reach any oil production cutting agreement for several months (please refer to our discussion on this topic below). Finally, our Risk-On/Safe-Haven currency ratio1 is in free fall and will likely reach its 2015 lows before troughing (Chart I-11). This ratio tightly correlates with EM share prices, and the latter remains vulnerable to further downside as long as this ratio is falling. Chart I-10EM Currencies Move In Tandem With Commodities Prices Chart I-11More Downside In Risk-On/ Safe-Haven Currency Ratio   Bottom Line: Although we are taking profits on the short EM equity position, we continue to recommend short positions in a basket of EM currencies – BRL, CLP, ZAR, IDR, PHP and KRW – versus the US dollar. Liquidation in EM fixed-income markets has been sharp, but the duration has been short –only a few weeks. Large losses will trigger more outflows from EM fixed-income markets. Stay defensive for now. What We Do Know And What We Cannot Know Amid such extreme uncertainty, it is critical for investors to distinguish between what we know and what we cannot know. What we cannot know: With regards to COVID-19: The speed of its spread, the ultimate number of victims it claims and – finally – its impact on consumer and business confidence and psyche. Related to lockdowns: Their duration in key economies. These questions will largely determine this year’s economic growth trajectory: Will it be V-, U-, W-, or L-shaped? Unfortunately, no one knows the answers to the above questions to have any certainty in projecting this year’s global growth. The key factor that gives Russia an advantage over Saudi Arabia in terms of its ability to deal with a negative terms-of-trade shock is not only its better fiscal position but also its ability to depreciate its currency. What we do know: Authorities in all countries will stimulate aggressively so long as financial markets are rioting. Nonetheless, these stimulus measures will not boost growth immediately. With entire countries locked down and plunging consumer and business confidence, stimulus will not have much impact on growth in the near term. In brief, all policy stimulus will boost growth only when worries about the pandemic subside and the economy begins to function again. Both are not imminent. Hence, we are looking at an air pocket with respect to near-term global economic growth. As we argued in our March 11 report titled, Unraveling Of The Policy Put, the pre-coronavirus financial market paradigm – where stocks and credit markets were priced to perfection because of the notion that policymakers would not allow asset prices to drop – has unravelled.   In recent weeks, policymakers around the world have announced plans to deploy massive amounts of stimulus, yet the reaction of financial markets has been underwhelming. The reason is two-fold: Both demand shrinkage and production shutdowns have just started, and they will run their due course regardless of announced policy stimulus measures. Equity and credit markets were priced for perfection before this selloff, and investors are in the process of recalibrating risk premiums. Provided the ongoing negative confidence shock and lingering uncertainty persist, odds are that the risk premium will initially overshoot before settling down. Consistently, risk markets will undershoot in the interim. Bottom Line: DM’s domestic demand downturn is still in its initial phase, and there is little foresight in terms of the pandemic’s evolution. These are natural forces, and any stimulus policymakers enact are unlikely to preclude them from occurring. Reflecting the economic contraction and heightened uncertainty, the selloff in risk assets will likely continue for now. Do Not Bet On An Early Resuscitation Of OPEC 2.0 As we argued in our March 11 report, Russia is unlikely to make a deal with Saudi Arabia to restrain oil output in the immediate term. Russia may agree to restart negotiations, but it will not agree to reverse its position for some time. Both nations will be increasing crude output (Chart I-12). As a result, a full-fledged oil market share war is underway. Consistently, crude prices have experienced a structural breakdown (Chart I-13).  Chart I-12The Largest Oil Producers Are Ramping Up Output Chart I-13Structural Breakdown In Oil Prices   The key factor that gives Russia an advantage over Saudi Arabia in terms of its ability to deal with a negative terms-of-trade shock is not only its better fiscal position but also its ability to depreciate its currency. Russia has a flexible exchange rate, which will allow the currency to depreciate in order to soften the blow from lower oil prices on the real economy and fiscal accounts. The Russian economy and financial system have learned to operate with recurring major currency depreciations. Saudi Arabia has been running a fixed exchange rate regime since 1986 and cannot use currency depreciation to mitigate the negative terms-of-trade shock on its end. Even though Russia’s fiscal budget break-even oil price is much lower than that of Saudi Arabia’s, it is not the most important variable to consider in this confrontation. The fiscal situation in both Russia and Saudi Arabia will not be a major problem for now. Both governments can issue local currency and US dollar bonds, and there will be sufficient demand for these bonds from foreign and local investors. This is especially true with DM interest rates sitting at the zero-negative territory. Falling oil prices and downward pressure on exchange rates will trigger capital outflows in both countries. Russia has learned to live with persistent capital flight. In the meantime, capital outflows will stress Saudi Arabia’s financial system and, eventually, its real economy. This is in fact the country’s key vulnerability. We will be publishing a Special Report on Saudi Arabia in the coming weeks.  Bottom Line: Do not expect a quick recovery in oil prices. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1     Average of CAD, AUD, NZD, BRL, RUB, CLP, MXN & ZAR total return indices relative to average of CHF & JPY total returns.   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights The path of least resistance for the DXY remains up. The internal dynamics of financial markets remain constructive for the DXY. We explore more key indicators to complement the analysis in our February 28 report. Our limit buy on NOK/SEK was triggered at parity. We were also stopped out of our long petrocurrency basket trade, which we will re-establish in the coming weeks. Feature Riot points in capital markets usually elicit a swathe of differing views. But more often than not, the internal dynamics of financial markets usually hold the key to a sober view. Given market action over the past few weeks, we are reviewing a few of the key indicators we look at for guidance on buying opportunities as well as false positives. In short, it is a story of standing aside on the DXY for now, while taking advantage of a few opportunities at the crosses. Currency Market Indicators Chart I-1The Dollar Has Scope To Rise Further Many currency market signals continue to point to a higher DXY index for the time being. One of our favorite risk-on/risk-off pairs is the AUD/JPY cross. Not surprisingly, it tends to correlate very strongly with the dollar, which is a counter-cyclical currency. The AUD/JPY cross has consistently bottomed at the key support zone of 70-72 since the financial crisis. This defensive line held notably during the European debt crisis, China’s industrial recession, and more recently, the global trade war. The latest market moves have nudged it decisively lower (Chart I-1). This pins the next level of support in the 55-57 zone, at par with the recessions of 2001 and 2008. The yen appears headed towards 100. A rising yen is usually accompanied by a dollar rally against other procyclical currencies. Outside of the Fukushima crisis, this was a key indicator that the investment environment was becoming precarious (Chart I-2). We laid out our conviction last week as to why we thought 100 is the resting spot for the yen.1 That said, in our trades, our 104 profit target for short USD/JPY was hit this week. We are reinstating this trade with a target of 100, but tightening the stop to 105.4. Chart I-2The Yen Rally Usually Stalls At 100 The recent drop in the dollar is perplexing to most, but it fits the profile of most recessions we have had in recent history. As the world’s reserve bank, the Federal Reserve tends to be the most proactive during a crisis. This means US interest rates drop faster than in the rest of the world, which tends to pressure the dollar lower. Eventually, as imbalances in the economic system come home to roost, the dollar rallies (Chart I-3). 62% of global reserves are still in dollars, suggesting it remains the currency of choice in a crisis. Currencies such as the Norwegian krone and Swedish krona that were already quite cheap are still selling off indiscriminately. Granted, the Norwegian krone has been hit especially hard due to the fallout of the OPEC cartel. But the Swedish krona and Australian dollar that were equally cheap are selling off as well. This suggests the currency market is making a binary switch from fundamentals to sentiment, as we highlighted last week. Chart I-3The Dollar And ##br##Recessions Chart I-4Carry Trades: Long-Term Bullish, Short-Term Cautious Correspondingly, high-beta currencies such as the RUB/USD, ZAR/USD and BRL/USD are plunging into uncharted territory. These currencies are usually good at sniffing out a change in the investment landscape, specifically one becoming precarious for carry trades. The message so far is that the drop in US bond yields may not have been sufficient to make these currencies attractive again (Chart I-4). On a similar note, it is interesting that the USD/CNY is still holding near the 7-defense line. We suggested in a previous report that this represented a handshake agreement between President Xi and President Trump during the trade negotiations. Should USD/CNY break decisively above 7.15 (for example, if Trump’s reelection chances dwindle), it will send Asian currencies into the abyss. The velocity of asset price moves is both surprising and destabilizing. At this rate, previously solvent countries can rapidly step into illiquid territory, especially those with already huge levels of external debt. Granted, this is more a problem for emerging markets than for G10 currencies. So far, it is encouraging that cross-currency basis swaps for the dollar (a measure of currency hedging costs) remain muted (Chart I-5). Chart I-5Hedging Costs Remain Contained In a nutshell, the message from currency markets warns against shorting the DXY for now. Bottom Line: Our profit target on short USD/JPY was hit at 104 this week. We are reinstating this trade with a new target of 100 and a stop-loss at 105.4. Currency market dynamics suggest the DXY is headed higher in the near term. The Message From Equity And Commodity Markets Equity and commodity market indicators continue to suggest the path of least resistance for the DXY remains up over the next few weeks. Since the 2009 lows, the S&P 500 has respected a well-defined upward-sloped trend line, characterized by a series of higher highs and lows. Given this defense line has been tested (and broken), it could pin the S&P 500 around 2200-2400 (Chart I-6). A further drop of this magnitude is likely to unravel financial markets as stop losses are triggered and reinforced selling is supercharged. Non-US equity markets have a much higher concentration of cyclical stocks in their bourses. Thus, whenever cyclical sectors are underperforming defensives at the same time as non-US markets are underperforming US ones, it is a clear sign that the marginal dollar is rotating towards the US (in this case fixed income). During the latest downdraft, what has been clear is that cyclical (and non-US) markets have been underperforming from already oversold levels (Chart I-7A and Chart I-7B). As contrarian investors, we tend to view this development positively, but catching a falling knife before eventual capitulation can also be quite painful. Chart I-6A Break Below The Defense Line Is Bearish Chart I-7ANot A Bullish Configuration For Cyclical Currencies Chart I-7BNot A Bullish Configuration For Cyclical Currencies The 2015-2016 roadmap was instructive on when such a capitulation might occur. Even as the market was selling off, certain cyclical sectors such as industrials started to outperform defensives ones (Chart I-8). So far, it appears that selling pressure in cyclical markets have not yet been exhausted. Chart I-8Equity Market Internals Are Worrisome In commodity markets, the copper-to-gold and oil-to-gold ratios continue to head lower from oversold levels. Together with the fall in government bond yields, it signifies that the liquidity-to-growth transmission mechanism is impaired (Chart I-9). The speed and magnitude of the latest drop could signify capitulation, but since the European debt crisis there has been ample time to catch the upswings, since they tend to be powerful and durable. Earnings revisions continue to head lower across all markets. Bottom-up analysts are usually spot on about the direction or earnings. Not surprisingly, the downgrades have been driven by emerging markets, meaning that return on capital will be lower in cyclical bourses. Chart I-9Commodity Market Internals Are Worrisome A selloff in equity markets has tended to occur in cycles. The speed and intensity of the first selloff usually wipes out stale longs, especially those that bought close to the recent market peak. It is fair to assume with yesterday’s selloff that the process is near complete. The next wave comes from medium-term investors, making a judgment call on whether they are at the cusp of a recession. Unfortunately, this phase usually involves a cascading selloff with capitulation only evident a few weeks or months later. The fact that cheap and deeply oversold currencies like the Norwegian krone and Australian dollar are still falling suggests we are stepping into the second wave of selloffs. What remains peculiar about the dollar is that it continues to be whipsawed between relative fundamentals and sentiment. Bottom LIne: Equity market internals continue to suggest we have not yet hit a capitulation phase for pro-cyclical currencies. Stand aside on the DXY for now. On Interest Rates, The Euro, And Petrocurrencies Chart I-10The Bear Case For The US Dollar What remains peculiar about the dollar is that it continues to be whipsawed between relative fundamentals and sentiment. For example, interest rate differentials across much of the developed world have risen versus the dollar, in stark contrast with the drop in their exchange rates (Chart I-10). The risk is that as a momentum currency, a surge in the dollar triggers a negative feedback loop that tightens global financial conditions, reinforcing the same negative feedback loop. A few questions we have fielded this week have been in surprise to the rise in the euro. What has been remarkable is that the drop in Treasury yields has wiped out the carry from being long the dollar for a number of countries. For example, the German bund-US Treasury spread continues to collapse. The message is that at least initially, room for policy maneuvering remains higher at the Fed, which corroborates the market view of a disappointing European Central Bank meeting this week. A drop in oil prices is also a huge dividend on the European economy, which partly explains recent strength in the euro. Within this sphere of multiple moving parts, one key question is what to do with oil plays. Usually recessions are triggered by rising oil prices that impose a tax on the domestic economy. But rather, oil prices have fallen dramatically in recent weeks as the pseudo-alliance between Russia and OPEC appears to have broken down. Our commodity and geopolitical strategists believe that while some sort of resolution will ultimately be reached, the path of least resistance for oil prices in the interim is down, as market share wars are re-engaged.2 Risks to oil demand are now also firmly tilted to the downside. Oil demand tends to follow the ebb and flows of the business cycle. Transport constitutes the largest share of global petroleum demand, and the rising bans on travel will go a long way in curbing consumption (Chart I-11). Balance-of-payment dynamics also tend to deteriorate during oil bear markets. Altogether, these forces combine to become powerful headwinds for petrocurrencies. A fall in oil prices tends to be bullish for the US dollar. This is because falling oil prices reduce government spending in oil-producing countries, which depresses aggregate demand and leads to easier monetary policy. Meanwhile, a fall in oil prices also implies falling terms of trade, which further reduces the fair value of the exchange rate. Balance-of-payment dynamics also tend to deteriorate during oil bear markets. Altogether, these forces combine to become powerful headwinds for petrocurrencies. Chart I-11Oil Demand Will Collapse Further Chart I-12Resell CAD/NOK NOK Will Outperform CAD We were stopped out of our long petrocurrency basket trade for a small loss of 0.9% (on the back of a positive carry). We are standing aside on this trade for now. We were also stopped out of our short CAD/NOK trade which we are reinstating this week. Further improvement in Canadian energy product sales will require not only rising oil prices, but an improvement in pipeline capacity and a smaller gap between Western Canadian Select (WCS) and Brent crude oil prices. With the US shale revolution grabbing production market share from both OPEC and non-OPEC producing countries, the divergence between the WCS (and WTI) price of oil versus Brent is likely to remain wide (Chart I-12). Rebuy NOK/SEK Our limit buy on long NOK/SEK was triggered at parity this week. Relative fundamentals, especially from an interest rate perspective, still favor the cross. The cross has approached an important technical level, with our intermediate-term indicator signaling oversold conditions. Should the NOK/SEK pattern of higher lows and higher highs in place since the 2015 bottom persist, we should be on the cusp of a reversal (Chart I-13). Interest rate differentials continue to favor the NOK over the SEK (Chart I-14). Meanwhile, Norway mainland GDP growth continues to outpace that of Sweden. Chart I-13Rebuy NOK/SEK Rebuy NOK/SEK Chart I-14A Yield Cushion The risk to this trade is that we have not yet seen a capitulation in oil prices. This will largely be driven by geopolitics. But given that the cross is already trading near the 2016 lows in oil prices, this has already largely been priced in. We are placing a tight stop at 0.94 to account for volatility in the coming weeks. Housekeeping Our short CHF/NZD trade briefly hit our stop loss of 1.75. We are reinstating this trade today, with a new entry level of 1.74 and a stop-loss of 1.76. We were also stopped out of our short USD/NOK trade, and we will look to rebuy the krone in the near future. Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Weekly Report, titled “Are Competitive Devaluations Next?”, dated March 6, 2020, available at fes.bcaresearch.com. 2 Please see Commodity & Energy Strategy Special Report, titled “Russia Regrets Market-Share War?”, dated March 12, 2020, available at ces.bcaresearch.com. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have been positive: Nonfarm payrolls increased by 275 thousand and average hourly earnings grew by 3% year-on-year in February. The NFIB business optimism index ticked up to 104.5 in February. Core CPI grew by 2.4% year-on-year from 2.3% in February. The DXY index appreciated by 0.8% this week. Core inflation has consistently printed at or above 2% for the last two years, but with inflation expectations plunging to new lows, the February print is likely to mark an intermediate-term high in CPI. As a counter-cyclical currency, the DXY is likely to continue getting a bid in the near term, even if we get more aggressive stimulus from the Fed. Report Links: Are Competitive Devaluations Next? - March 6, 2020 The Near-Term Bull Case For The Dollar - February 28, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been mixed: GDP grew by 1% year-on-year in Q4 2019, from 0.9% in Q3. The Sentix investor confidence index plummeted to -17.1 from 5.2 in March. Industrial production grew by 2.3% month-on-month in January from a contraction of 1.8% in December. The euro appreciated by 0.5% against the US dollar this week. The European Central Bank (ECB) kept rates unchanged at its Thursday meeting but implemented measures that support bank lending to small and medium-sized enterprises and injected liquidity through longer-term refinancing operations. The ECB also introduced additional net asset purchases of EUR 120 billion until the end of the year. This will help ease financial conditions in the euro area, but until global demand picks up, the exodus of capital from cyclical European stocks could continue.   Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been negative: The current account surplus increased to JPY 612.3 billion from JPY 524 billion while the trade balance went into a deficit of JPY 985.1 billion from a surplus of JPY 120.7 billion in January. Machine tool orders contracted by 30.1% year-on-year in February. The outlook component of the Eco Watchers survey plummeted to 24.6 from 41.8. The Japanese yen appreciated by 2.2% against the US dollar this week. An increase in foreign investments boosted the current account surplus, helping offset the deficit in goods trade. The government announced a package totaling JPY 430.8 billion to support financing for small businesses squeezed by the virus. The sharp rally in the yen could begin to garner discussions from both the MoF and BoJ on further actions. Report Links: The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the UK have been negative: GDP growth was flat month-on-month in January. Industrial production contracted by 2.9% year-on-year in January, from a contraction of 1.8% the previous month. The total trade balance shrank to GBP 4.2 billion from GBP 6.3 billion in January. The British pound depreciated by 2.2% against the US dollar this week. The Bank of England (BoE) responded to the Covid-19 shock with an emergency rate cut of 50 basis points. This dovetailed with the government’s announcement of a GBP 30 billion stimulus package financed largely by additional borrowing. With the policy rate at 0.25%, the BoE has ruled out negative rates so further easing will likely come in the form of QE if rates go to zero. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 United Kingdom: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been negative: The Westpac consumer confidence index fell to 91.9 from 95.9 in February, a five-year low. National Australia Bank business confidence decreased to -4 from -1 while business conditions fell to 0 from 2 in February. Home loans grew by 3.1% month-on-month in January, from 3.6% the previous month. The Australian dollar depreciated by 3.9% against the US dollar this week. The Australian government joined other economies in announcing a stimulus package worth more than $15 billion that includes an extension of asset write-offs and measures to protect apprenticeships across the country. Reserve Bank of Australia Deputy Governor Debelle confirmed that the bank would consider quantitative easing if necessary. Report Links: On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been negative: Manufacturing sales grew by 2.7% quarter-on-quarter in Q4 2019. The preliminary ANZ business confidence numbers plummeted to -53.3 from -19.4 in March. Export intentions, at -21.5, hit an all-time low in March. Electronic card retail sales grew by 8.6% year-on-year in February, picking up from 4.2% in January. The New Zealand dollar depreciated by 1.9% against the US dollar this week. The government is planning a business continuity package that will be ready in coming weeks. Reserve Bank of New Zealand Governor Orr stated that the bank would consider unconventional policy such as negative rates, interest rate swaps, and large scale asset purchases only if policy rates hit the effective zero bound. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 USD/CNY And Market Turbulence - August 9, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been mixed: Average hourly earnings grew by 4.3% year-on-year and 30.3 thousand new jobs were added to the Canadian economy in February. Imports fell to CAD 49.6 billion, exports fell to CAD 48.1 billion, and the deficit in international merchandise trade swelled to CAD 1.47 billion in February.  The Ivey PMI decreased to 54.1 from 57.3 on a seasonally-adjusted basis in February. The Canadian dollar depreciated by 3% against the US dollar this week. The petrocurrency sold off as oil plunged in its biggest decline since the Gulf War in 1991. Exports of motor vehicles and energy products were down, contributing to the widening deficit. Supply and demand factors are bearish for oil, which will put a floor under our long EUR/CAD trade. Report Links: The Loonie: Upside Versus The Dollar, But Downside At The Crosses Updating Our Balance Of Payments Monitor - November 29, 2019 Making Money With Petrocurrencies - November 8, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 There were scant data out of Switzerland this week: The unemployment rate remained flat at 2.3% in February. Foreign currency reserves increased to CHF 769 billion from CHF 764 billion in February while total sight deposits ticked up to CHF 598.5 billion from CHF 503.6 billion in the week ended March 6.   The Swiss franc appreciated by 0.7% against the US dollar this week. The franc was driven by safe-haven flows at the beginning of the week but sold off as the market posted a tentative rally. Sight deposit and reserve data suggest the Swiss National Bank (SNB) intervened to keep EUR/CHF above the key 1.06 level. The ECB’s decision to hold rates will take some pressure off the SNB. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway have been negative: Headline CPI grew by 0.9% from 1.8% while the core figure grew by 2.1%, slowing from 2.9%, in February. Manufacturing output contracted by 1.4% month-on-month in January. The PPI contracted by 7.4% year-on-year in February, deepening the contraction of 3.9% the previous month. The Norwegian krone depreciated by 8.2% against the US dollar this week. As expected, the currency was hit hard by tumbling oil prices. The government is set to present emergency measures which will target bankruptcies and layoffs in sectors hit hard by Covid-19, such as airlines, hotels, and parts of the manufacturing industry. There may also be scope for the government to directly stimulate demand in the oil industry. Report Links: Building A Protector Currency Portfolio - February 7, 2020 On Oil, Growth And The Dollar - January 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2   There were scant data out of Switzerland this week: The current account surplus shrank to SEK 39 billion from SEK 65 billion in Q4 2019. The Swedish krona depreciated by 3% against the US dollar this week. The Swedish government announced a SEK 3 billion supplementary budget bill to combat the shock from Covid-19, in addition to preexisting tax credits and an extra SEK 5 billion promised to local authorities in the upcoming spring mini-budget. Riksbank Governor Ingves emphasized the need to maintain liquidity via more generous terms for loans to banks or direct purchases of securities. A rate cut, however, does not seem to be on the table. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

  Highlights China should fare a global recession better than most G20 economies, given its large domestic market and powerful policy response. China is likely to frontload a large portion of its multi-year infrastructure investment projects to this year. We project a near 10% increase in infrastructure investments in 2020. While at the moment we do not have high conviction in the absolute trend in Chinese stock prices, we think Chinese equities will still passively outperform global benchmarks in a global recession. Feature Chart 1A Black Monday Triggered By A "Perfect Storm" Investors are now pricing in a global recession, triggered by a worsening COVID-19 epidemic outside of China and a full-blown price war in the oil market. Global stocks tumbled by 7% on Monday March 9 while the US 10-year Treasury yield dropped to a record low (Chart 1).  This extreme volatility reflects investors’ inability to predict how the epidemic will evolve or how long the oil price war will persist. If growth in the US and other major economies turns negative, then China’s disrupted supply side in Q1 will be met with weaker global demand in Q2 and even Q3. While our visibility is limited on the predominantly medically- or politically-oriented crisis, what we have conviction in forecasting at this point is that the Chinese economy will weather the storm better than most G20 economies. China’s policy response and the recovery in domestic demand will more than offset weaknesses from external demand. Thus Chinese stocks will likely outperform global benchmarks in the next 3 months and over a 6-12 month span, even though the absolute trend in both Chinese and global stock prices remains unclear over both these time horizons. A One-Two Punch In a recessionary scenario affecting the entire global economy, China would receive a one-two punch through shocks to both supply and demand tied to the COVID-19 outbreak and shrinking global demand. However, while a global recession would impact China’s export growth, it would not have the kind of bearing on China’s aggregate economy as it did in either 2008/2009 or 2015/2016. The reason is that the Chinese economy is less reliant on exports than it was in 2015 and considerably less than in 2008 (Chart 2). Domestic demand is now dominant, accounting for more than 80% of China’s economy, meaning that the country is less vulnerable to reductions in global demand. Chart 2The Chinese Economy Is Much Less Reliant On Exports Chart 3Global Economy Showing Reflation Signs Before COVID-19 Our current assessment is that the shocks from the virus epidemic and oil price rout on global demand will be brief.Global manufacturing and trade were on a path to recovery prior to the crisis (Chart 3). China’s external and domestic demand rebounded sharply in December and likely have improved even further until late January when the COVID-19 outbreak took hold in China (Chart 4). Even though China’s trade figures in the first two months of 2020 were distorted by COVID-19 (Chart 5),1 a budding recovery in both China’s domestic and global demand before the outbreak suggests the epidemic should disrupt rather than completely derail the global economy. Moreover, a rebound in trade following the crisis will likely be powerful, as the short-term disruption in business activities will lead to a sizable buildup in manufacturing orders. A rebound in trade following the crisis will likely be powerful. Chart 4Chinese Exports Likely To Have Improved Further Until COVID-19 Hit Chart 5Chinese Demand Likely To Pick Up Sharply In Q2   Bottom Line: China’s export growth will moderate if the virus outbreak prolongs and substantively weakens the global economy. However, the demand shock should have a relatively minor impact on China’s aggregate economy and the subsequent recovery should be robust. Infrastructure Investment Comes To Rescue, Again Chart 6Substantial Acceleration In Infrastructure Investment Likely In 2020 Infrastructure investment in China will likely ramp up significantly in 2020, which will mitigate the influence on the domestic economy from both COVID-19 and slowing global growth. The message from the March 4th Politburo Standing Committee2 chaired by President Xi Jinping further supports our view, that Chinese policymakers are committed to a major increase in infrastructure investment in 2020. Our baseline projection suggests a near 10% increase in infrastructure investment growth in 2020 (Chart 6). Local governments’ infrastructure investment plans for the next several years amount to about 34 trillion yuan.3 While local government budget and bond issuance will be approved at the annual National People’s Congress, which is delayed due to the epidemic, we have high conviction that a significant portion of the planned spending will be frontloaded this year. A significant portion of the multi-year infrastructure projects will likely be moved up to this year. In the first two months, local governments have frontloaded 1.2 trillion yuan worth of bonds, including nearly 1 trillion yuan of special-purpose bonds (SPBs). The consensus forecasts a total of 3-3.5 trillion yuan of SPBs to be issued in 2020, a 30% jump from 2019. Given tightened restrictions on the use of SPBs, we expect that 50% of the bonds will be invested in infrastructure projects, up from about 25% from 2019. This should contribute to about 10-15% of infrastructure spending in 2020. We are likely to also see significant additional funding channels to support infrastructure spending this year: Debt-swap program: With the aggressive easing by the PBoC in recent weeks, there is a high probability that another round of debt-swap program will materialize this year – a form of fiscal stimulus similar to the debt-to-bond swap program that the Chinese government initiated during the 2015-2016 cycle (Chart 7).  As we pointed out in our report dated July 24, 2019, the Chinese authorities were formulating another round of local government off-balance-sheet debt swaps, which we estimated would be about 3-4 trillion.4 What was absent back then was a concerted effort from the PBoC to equip commercial banks with the required liquidity and further lower policy rate (Chart 8). Both monetary and policy conditions are now ripe for such a program to be rolled out. Chart 7Money Supply Likely To Pick Up Strongly At The Onset Of Substantial Stimulus Chart 8Monetary Conditions Are Ripe For Major Money Base Expansion   Construction bond issuance: Borrowing through local government financing vehicles (LGFV) has climbed since the second half of last year. This follows two years of tightened regulations on local government borrowing. Net issuance of urban construction investment bonds (UCIB) reached 1.2 trillion in 2019, nearly doubling the amount from a year earlier. A total of 457 billion yuan in UCB has already been issued in the first two months of 2020, which indicates that the authorities are further relaxing LGFV borrowing.  We think that net UCIB issuance could reach 1.5 trillion this year, a 25% increase compared with last year. Chart 9More Room To Widen Government Budget Deficit Government budget:  Funding from the central and local governments budgets accounts for about 15% of overall infrastructure financing. We think that the government budget deficit will likely expand by about 2% of GDP in 2020. As Chart 9 shows, this figure is a conservative estimate compared with the 3%+ widening in the budget deficit during the 2008 and 2015 easing cycles. Bottom Line: Fiscal efforts to support the economy will significantly escalate this year. Monetary conditions and policy directions have already paved the way for a 2015-2016 style credit expansion. We expect infrastructure investment to rise to about 10% in 2020 compared with 2019. Will The RMB Join The Devaluation Club? The RMB appreciated by more than 1% against the USD in the past week, fanned by the expectation that China will have a faster recovery than other countries. The latest round of interest rate cuts by central banks around the world also pushed yield-seeking investors to RMB assets (Chart 10). Still, it is highly unlikely that the PBoC will allow the RMB to continue to appreciate at this rate. When other economies are in a competitive currency devaluation cycle, a strong RMB will generate deflationary headwinds for China’s economy and will partially offset the PBoC’s easing efforts (Chart 11). Chart 10Too Much Too Fast? Chart 11A Strong RMB Will Choke Off PBoC's Easing Efforts If the upward pressure in the RMB persists, then Chinese policymakers will be more inclined to expand the money base. Chart 12PBoC Likely To Rapidly Expand Its Balance Sheet Again We do not expect the PBoC to follow the US Federal Reserve and chase its policy rate even lower.  However, if the upward pressure in the RMB persists, then Chinese policymakers will be more inclined to expand the money base. This further raises the probability that local government debt-swap programs will develop this year (Chart 12). The government may allow financial institutions to extend or swap maturing local government off-balance sheet debt with bank loans that carry lower interest rates and longer maturities. Or, it will simply move the debt to the PBoC’s balance sheet. Bottom Line: If upward pressure in the RMB endures, the PBoC will likely expand its balance sheet and make more room to buy local government debt, but it is unlikely to aggressively cut interest rates. Investment Conclusions Chart 13Chinese Stocks Will Likely Continue To Outperform, Even In A Global Recession Our recent change in view5 concerning the willingness of Chinese authorities to “stimulate the economy at all costs” meant that Chinese stocks were likely to outperform the global benchmarks in a rising equity market.  In a global recessionary, which is now a fait accompli, Chinese leadership’s willingness to stimulate the economy will only intensify. China’s large domestic economy also makes the country less vulnerable to a global demand shock. At this point in time we do not have high conviction in the absolute trend in either Chinese or global stock prices, as their near-term performance is predominantly driven by a medically- and politically-oriented crisis. However, as we expect the Chinese economy to outperform in a global recession, our overweight call on Chinese equities remains intact on both a 3-month and 12-month horizon, in relative terms (Chart 13).   Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1    China had postponed January’s data release and instead, has combined the first two months of the year. 2   “We should select investment projects; strengthen policy support for land use, energy use, and capital; and accelerate the construction of major projects and infrastructure that have been clearly identified in the national plan.” http://cpc.people.com.cn/n1/2020/0305/c64094-31617516.html?mc_cid=2a979… 3   https://m.21jingji.com/article/20200306/504edc15217322ab37337da2ca35a49e.html?[id]=20200306/nw.D44010021sjjjbd_20200306_9-01.json  4   Please see China Investment Strategy Weekly Report "     Threading A Stimulus Needle (Part 2): Will Proactive Fiscal Policy Lose Steam?," dated July 24, 2019, available at cis.bcaresearch.com 5   Please see China Investment Strategy Weekly Report "China: Back To Its Old Economic Playbook?," dated February 26, 2020, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Highlights The latest interest rate cuts by central banks confirms the narrative that the authorities view economic risks as asymmetrical to the downside. This all but assures that competitive devaluation will become the dominant currency landscape in the near future. If the virus proves to be just another seasonal flu, the global economy will be awash with much more stimulus, which will be fertile ground for pro-cyclical currencies. In the event that we get a much more malignant outcome, discussions around interest rate cuts will rapidly evolve into quantitative easing and debt monetization. The dollar will be the ultimate loser in both scenarios, but this path could be lined with intermediate strength. Our highest-conviction call before the dust settles is to short USD/JPY. We are also making a few portfolio adjustments in light of recent market volatility. Buy NOK/SEK and NZD/CHF and take profits soon on long SEK/NZD. Feature The DXY rally that began last December faltered below overhead psychological resistance at 100, and has since broken below key technical levels. The V-shaped reversal has been a mirror image of developments in equity markets, with the S&P 500 off 6% from its lows. The catalyst was aggressive market pricing of policy action from the Federal Reserve, to which the authorities yielded. The latest policy action confirms the narrative that most central banks continue to view deflation as a much bigger threat than inflation, since few have been able to achieve their mandate. This all but assures that competitive devaluation will become the dominant currency landscape, as each central bank prevents appreciation in their respective currency. Should the Fed continue on the path of much more aggressive stimulus, this will have powerful implications for the dollar and across both G10 and emerging market currencies.   The US 10-year Treasury yield broke below 1% around 1:40 p.m. EST on March 3rd. This was significant not because of the level but because it emblematically erased the US carry trade for a number of countries (Chart I-1). Should the Fed continue on the path of much more aggressive stimulus, this will have powerful implications for the dollar and across both G10 and emerging market currencies.  Chart I-1The Big Convergence To Buy Or Sell The DXY? If the virus proves to be only slightly more lethal than the seasonal flu, the global economy will be awash with much more stimulus, which will be fertile ground for pro-cyclical currencies. As a counter-cyclical currency, the dollar will buckle, lighting a fire under our favorites such as the Norwegian krone and the Swedish krona. The euro will be the most liquid beneficiary of this move. Chart I-2 shows that the global economy was already on a powerful V-shaped recovery path before the outbreak. More importantly, this recovery was on the back of easier financial conditions. Chart I-2V-Shaped Recovery At Risk Chart I-3A Second Wave Of Infections? Our roadmap is the peak in the momentum of new infections outside of China. During the SARS 2013 episode, the bottom in asset prices (and peak in the DXY) occurred when the momentum in new cases peaked. Currency markets are currently pricing a much worse outcome than SARS. The risk is that we are entering a second wave of infections outside Hubei, China, which will be more difficult to control than when it was relatively more contained within the epicenter (Chart I-3). As we aptly witnessed a fortnight ago, currency markets will make a binary switch to risk aversion on such an outcome. This warns against shorting the DXY index or buying the euro or pound in the near term. As we go to press, the virus has been identified on almost every continent except Antarctica. Even in countries such as the US, with modern and sophisticated health facilities, the costs to get tested are exorbitant for underinsured individuals.1 This all but assures that the number of underreported cases is likely non-trivial, which could trigger another market riot once they surface. Chart I-4DXY and USD/JPY Tend To Move Together Our highest-conviction call before the dust settles is therefore to short USD/JPY. As Chart I-1 highlights, the Bank of Japan is much closer to the end of their rope in terms of monetary policy tools. Long bond yields have already hit the zero bound, which means that real rates in Japan will continue to rise until the authorities are forced to act. One of the triggers to act will be a yen soaring out of control, which is not yet the case. Speculative evidence is that it will take a yen rally in the order of 12% to catalyze the BoJ. More importantly, the speed of the rally will matter. This was the trigger for negative interest rates in January 2016 as well as yield curve control in September of 2016. The first rally from USD/JPY 125 to around 112 and the subsequent rise towards 100 were both in the order of 12%. A similar rally from the recent peak near 112 will pin the USD/JPY at 100.   Bottom Line: The yen is the most attractive currency to play dollar downside at the moment. Remain short USD/JPY. If global growth does pick up and the dollar weakens, the USD/JPY and the DXY tend to be positively correlated most of the time, providing ample room for investors to rotate into more pro-cyclical pairs (Chart I-4). Competitive Devaluation? In the event that we get a much more malignant outcome, discussions around interest rate cuts will rapidly evolve into quantitative easing and debt monetization. The Reserve Bank of Australia has already stated that QE is on the table if rates touch 0.25%.2 Other central banks are likely to follow suit. As the chorus of central banks cutting rates and stepping into QE on COVID-19 rises, the rising specter of currency brinkmanship is likely to unnerve countries pursuing more orthodox monetary policies. The currency of choice will be gold and other precious metals, though the dollar, Swiss franc, and yen are likely to also outperform.  The velocity of money in both the US and the euro area was in a nascent upturn, but has started to roll over.  Whether or not countries adopt QE, what is clear is that balance sheet expansion at both the Fed and the European Central Bank is set to continue. Chart I-5 shows that the velocity of money in both nations was in a nascent upturn, but has started to roll over. This tends to lead inflation by a few quarters. On a relative basis, our bias is that the pace of expansion should be more pronounced in the US. This will eventually set the dollar up for a significant decline, albeit after a knee-jerk rally. Chart I-5ADownside Risks To US Inflation Chart I-5BDownside Risks To Euro Area Inflation In terms of quantitative easing, it is most appealing when a country has low growth, low inflation, and large amounts of public debt. If we are right that inflation is about to roll over in the US, then the public debt profile and political capital to expand the budget deficit places the nation as a prime candidate for QE (Chart I-6). Fiscal stimulus is a much more difficult discussion in Europe, Japan, or elsewhere for that matter, and likely to arrive late. Chart I-6US Government Debt Is Very High The backdrop for the US dollar is a 37% rise from the bottom. The New York Fed estimates that a 10 percentage point appreciation in the dollar shaves 0.5 percentage points off GDP growth over one year, and an additional 0.2 percentage points in the following year.3 With growth now hovering around 2%, a strong currency could easily nudge US growth to undershoot potential.  The Fed is one of the few G10 central banks with room to ease monetary policy. This sets the dollar up for an eventual decline. However, the path to QE will be lined by a strong dollar if the backdrop is flight to safety. This entails rolling currency depreciations among some developed and emerging markets. When looking for the next candidates for competitive devaluation, the natural choices are the countries with overvalued exchange rates that are exerting a powerful deflationary impulse into their economies. Chart I-7 shows the deviation of real effective exchange rates from their long-term mean, according to the BIS. Chart I-7Competitive Devaluation Candidates Bottom Line: The Fed is one of the few G10 central banks with room to ease monetary policy. This sets the dollar up for an eventual decline. It will first occur among the safe havens (currencies with already low interest rates), before it rotates to more procyclical currencies. Where Does US Politics Fit In? Politics should start to have a meaningful impact on the dollar once the democratic nominee is sealed. Super Tuesday revealed a powerful shift to the center, pinning former Vice President Joe Biden as the preferred candidate (Chart I-8). The dollar tends to thrive as political uncertainty rises. While not a forgone conclusion, a Sanders–Trump rivalry would have been a very polarized outcome, putting a bid under the greenback. Markets are likely to take a more conciliatory tone from a Biden victory, which will be negative for the greenback.   Chart I-8US Politics Will Be Important Our colleague Matt Gertken, chief geopolitical strategist, just published his analysis of Super Tuesday.4 While a contested convention remains unlikely, it will likely favor Trump’s reelection odds. What is common about a Biden-Sanders-Trump trio is that fiscal policy is set to expand in the US. This will ultimately be dollar bearish (Chart I-9). Chart I-9The Dollar And Budget Deficits Bottom Line: The election is still many months away and much can change between now and then. For now, Biden is the preferred democratic nominee. Portfolio Adjustments Chart I-10Sell CHF/NZD The sharp rally in the VIX index has opened up a trading opportunity on the short side. The historical pattern of previous spikes in the VIX is that unless the market starts to price in an actual recession, which is quite plausible, the probability of a short-term reversal is close to 100%. Given our base case that we are not headed for a recession over the next six to 12 months, we are opening a short CHF/NZD trade today. The cross tends to benefit from spikes in volatility, correcting sharply as the market unwinds overreactions. More importantly, the cross has already priced in an overshoot in the VIX in an order of magnitude akin to 2008. Place stops at 1.75 with a target of 1.45 (Chart I-10). We are also placing a limit buy on NOK/SEK at parity. The risk to this trade is a further down-leg in oil prices, but at parity, the cross makes for a compelling tactical trade. Momentum on the cross is currently bombed out. We will be closely watching whether Russia complies with OPEC production cuts and act accordingly. Remain long NOK within our petrocurrency basket against the euro. We are also looking to take profits on our long SEK/NZD trade, a nudge below our initial target. The market has fully priced in a rate cut by the Reserve Bank of New Zealand, suggesting the kiwi could have a knee-jerk rally, similar to the Aussie on the actual announcement. Finally, we were stopped out of our short gold/silver trade for a loss of 5.5%. We will be looking to re-establish this trade in the coming weeks. Stay tuned. Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Bertha Coombs and William Feuer, “The coronavirus test will be covered by Medicaid, Medicare and private insurance, Pence says,” CNBC, dated March 4, 2020. 2 Michael Heath, “RBA Says QE Is Option at 0.25%, Doesn’t Expect to Need It,” Bloomberg News, dated November 26, 2019. 3 Mary Amiti and Tyler Bodine-Smith, “The Effect of the Strong Dollar on U.S. Growth,” Federal Reserve Bank of New York, dated July 17, 2015. 4  Please see Geopolitical Strategy Special Report, titled “US Election: A Return To Normalcy?”, dated March 4, 2020, available at gps.bcaresearch.com. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have been positive: The ISM manufacturing PMI fell slightly to 50.9, dragged down by the prices paid and new orders component, while the non-manufacturing index ticked up to 57.3. Core PCE inflation increased to 1.6% year-on-year in January. Unit labor costs came in at 0.9% quarter-on-quarter in Q4 of last year. This is a deceleration from the previous print of 2.5%. The DXY index depreciated by 1.4% this week. Following a conference call with G7 central banks, the Fed made an emergency rate cut of 50bps. Chairman Powell cited risks to the outlook from Covid-19 but acknowledged that the Fed can keep financial conditions accommodative, not fix broken supply chains or cure infections. Report Links: The Near-Term Bull Case For The Dollar - February 28, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Building A Protector Currency Portfolio - February 7, 2020 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been positive: Core CPI inflation increased slightly to 1.2% year-on-year in February.  The producer price index contracted by 0.5% year-on-year in January. The unemployment rate remained flat at 7.4% in January. Retail sales grew by 1.7% year-on-year in January, remaining flat from the previous month. The euro appreciated by 3.6% against the US dollar this week. As the ECB is limited by the zero lower bound, the euro strengthened on expectations that rate differentials with the US will continue to narrow. The ECB could resort to policy alternatives such as a special facility targeting small and medium enterprises. Markets are pricing in an 81% probability of a rate cut as we go into the ECB meeting next week. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been negative: The Tokyo CPI excluding fresh food grew by 0.5% year-on-year in February from 0.7% the previous month. The jobs-to-applicants ratio decreased to 1.49 from 1.57 while the unemployment rate increased to 2.4% from 2.2% in January. The consumer confidence index declined to 38.4 from 39.1 in February. Housing starts contracted by 10.1% year-on-year in January from 7.9% the previous month. The Japanese yen appreciated by 2.5% against the US dollar this week. Lower US yields, combined with continued risk-on flows, have extended the rally in the Japanese yen. Weakness in the Japanese economy is broad based, but the BoJ has limited policy space and fiscal action looks unlikely anytime soon. Global central bank action will drive the yen in the near term. Report Links: The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the UK have been mixed: Consumer credit decreased to GBP 1.2 billion from GBP 1.4 billion while net lending to individuals fell to GBP 5.2 billion from GBP 5.8 billion in January. Mortgage approvals increased to 70.9 thousand from 67.9 thousand in January, while the Nationwide housing price index grew by 2.3% year-on-year in February from 1.9% the previous month.  The British pound appreciated by 0.2% against the US dollar this week. At a hearing this week, incoming governor Andrew Bailey stated that the BoE is still assessing evidence on the nature of the shock from Covid-19. The BoE has limited room to cut and is constrained by possible stagflation; we expect targeted supply chain finance and cooperation with fiscal authorities to take precedence.   Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 United Kingdom: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been mixed: GDP grew by 2.2% year-on-year in Q4 2019, improving from 1.7% the previous quarter.  Imports and exports both contracted by 3% while the trade balance dropped to AUD 5.2 billion in January. Building permits contracted by a dramatic 15.3% month-on-month in January, compared to growth of 3.9% in December. The RBA commodity price index contracted by 6.1% year-on-year in February.  The Australian dollar appreciated by 0.8% against the US dollar this week. The Reserve Bank of Australia cut its official cash rate to 0.5%, an all-time low, citing the impact of Covid-19 on domestic spending, education, and travel. Watch to see if the signal from building permits is confirmed by other housing market indicators. The RBA might not be done easing. Report Links: On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been negative: The terms of trade index grew by 2.6% quarter-on-quarter in Q4 2019, improving from 1.9% in Q3. The ANZ commodity price index contracted by 2.1% in February, deepening from 0.9% the previous month. Building permits contracted by 2% month-on-month in January, from growth of 9.8% in December.  The global dairy trade price index contracted by 1.2% in March.  The New Zealand dollar appreciated by 0.3% against the US dollar this week. There is pressure on the Reserve Bank of New Zealand (RBNZ) to ease at its next meeting on March 27, with markets pricing in 42 basis points of easing over the next 12 months. However, the RBNZ has dispelled notions of a pre-meeting cut. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 USD/CNY And Market Turbulence - August 9, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been negative: Annualized GDP grew by 0.3% quarter-on-quarter in Q4 2019, slowing from 1.4% the previous quarter.  The raw material price index contracted by 2.2% and industrial product price index contracted by 0.3% month-on-month in January.  Labor productivity contracted by 0.1% quarter-on-quarter in Q4 2019, compared to growth of 0.2% the previous quarter. The Canadian dollar depreciated by 0.1% against the US dollar this week. The Bank of Canada (BoC) followed the Fed and cut rates by 50bps. In addition to the confidence hit from Covid-19, the BoC cited falling terms of trade, depressed business investment, and dampened economic activity due to the CN rail strikes. The BoC stands ready to ease further, and Prime Minister Trudeau has raised the possibility of a fiscal response.   Report Links: The Loonie: Upside Versus The Dollar, But Downside At The Crosses Updating Our Balance Of Payments Monitor - November 29, 2019 Making Money With Petrocurrencies - November 8, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been positive: GDP grew by 1.5% year-on-year in Q4 2019, from growth of 1.1% the previous quarter. The SVME PMI increased to 49.5 from 47.8 in February. The KOF leading indicator increased to 100.9 from 100.1 in February. CPI contracted by 0.1% year-on-year in February, from growth of 0.2% the previous month. The Swiss franc appreciated by 1.6% against the US dollar this week. A combination of strong domestic data and global risk-off flows contributed to strength in the Swiss franc. However, the Swiss government will be revising down growth forecasts and a recent UN report has estimated that Switzerland lost US$ 1 billion in exports in February due to Chinese supply disruptions. Combined with a strong franc, this puts the domestic outlook at risk.  Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway have been positive: The current account decreased to NOK 19.1 billion from NOK 29.5 billion in Q4 2019. The credit indicator grew by 5% year-on-year in January. Registered unemployment decreased slightly to 2.3% from 2.4% in February.  The Norwegian krone appreciated by 1.3% against the US dollar this week. Expect the petrocurrency to trade on news from the OPEC meetings in the coming days. The committee has proposed a production cut of 1.5 million barrels per day through Q2 2020, conditional on approval from Russia, to offset the demand shock from Covid-19.  Report Links: Building A Protector Currency Portfolio - February 7, 2020 On Oil, Growth And The Dollar - January 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been positive: The Swedbank manufacturing PMI increased to 53.2 from 52 in February. Industrial production grew by 0.9% year-on-year, from a contraction of 2.6% the previous month. GDP grew by 0.8% year-on-year in Q4 2019, slowing from 1.8% the previous month. The Swedish krona appreciated by 1.5% against the US dollar this week. After hitting a 2-decade high near 10, USD/SEK has violently reversed and is now trading at the 9.45 level. What is evident from incoming data is that the cheap currency has been a perfect shock absorber, cushioning the domestic economy. We are protecting profits on long SEK/NZD today and we will be looking for other venues to trade SEK on the long side.   Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights OPEC 2.0 ministers continue to negotiate oil production cuts to replace those expiring this month. We expect cuts of 1mm b/d – perhaps more – extending to end-June, undertaken to offset COVID-19-induced demand destruction. Making the not-unreasonable assumptions of no change in US sanctions-related output losses – 1mm b/d in Venezuela and 2mm b/d in Iran – and that 1mm b/d of Libyan output stays offline, the 1mm b/d cut coming out of this week’s meeting in Vienna will push average 1H20 OPEC 2.0 outages – planned and unplanned – to ~ 5mm b/d. The US economy is growing ~ 2.7% p.a., suggesting the Fed’s surprise 50bp rate cut this week is aimed at reducing global economic policy uncertainty (GEPU), lowering its accompanying USD safe-haven demand, and guarding against a collapse in US money velocity (Chart of the Week). This will weaken the USD, thereby supporting EM incomes and oil demand. We continue to expect policymakers in China to overshoot on fiscal and monetary stimulus, as they scramble to deliver 6% pa growth this year. Feature In the wake of ongoing negotiations – right into today’s meeting in Vienna – we expect OPEC 2.0 to deliver a production cut of at least 1mm b/d for 2Q20. Maybe more. Gulf Cooperation Council (GCC) states have been lobbying for a large cut – 1mm b/d at least. The Kingdom of Saudi Arabia’s (KSA) consistently lobbied for such cuts, and was instrumental in achieving the 1.7mm b/d output reduction for this quarter when the coalition met at the end of last year in Vienna. KSA’s partner in OPEC 2.0, Russia, has been slow to support production cuts going into this week’s meeting, which is the stance it typically takes during these negotiations. Nonetheless, it did agree in December to cuts, and we expect they will do so again this week. After this go-round, we’re likely to see an agreement to meet in June to determine whether cuts should be extended and/or expanded.1 Chart of the WeekFed Rate Cut Meant To Reduce Uncertainty The 1mm b/d in planned outages for 2Q20 coming out of this week’s meetings would add to the ~ 4mm b/d of unplanned outages in Venezuela, Iran and Libya this year. If the producer coalition fails to agree to a significant output cut this week, we would expect a sell-off in crude oil that takes Brent prices below $50/bbl, and WTI into the mid-$40s (Chart 2). An agreement to remove at least 1mm b/d of output likely will push Brent into the mid-$50s and WTI into the low-$50s during in 2Q20. Assuming the COVID-19 outbreak subsides by then, we expect Brent to rally in 2H20, with prices trading above $60/bbl and WTI trading $4/bbl below that on average. We will be updating our supply-demand balances and forecasts when we get fresh historical data from the key agencies (EIA, OPEC and IEA). The 1mm b/d in planned outages for 2Q20 coming out of this week’s meetings would add to the ~ 4mm b/d of unplanned outages in Venezuela, Iran and Libya. If these persist to end-June, planned and unplanned OPEC 2.0 production outages would average more than 5mm b/d in 1H20 (Chart 3). Chart 2A Failure To Cut Production Would Push Benchmark Crudes Lower Chart 3Core OPEC 2.0 Will Agree Cuts On the demand side, the big global hit to growth from China in 1Q20 should be out of the system by the end of 1H20, assuming the COVID-19 outbreak does not shut down global commerce the way it did in China. We think the odds of such a shutdown are low, given such policies only can be implemented by a central government in which all power is consolidated in a ruling party. Besides, given the massive hit to China’s manufacturing – auto production was down 80% y/y in February, e.g. – such policies are unlikely to be recommended in all but the most dire of circumstances. We continue to expect Chinese policymakers to overshoot on their fiscal and monetary stimulus, as they scramble to get 2020 GDP growth back above a 6% p.a. rate. Our view aligns with BCA’s China Investment Strategy, which last week observed, “It is becoming evident that the Chinese leadership is willing to abandon its financial de-risking agenda in exchange for a rapid economic recovery.”2 Our colleagues go on to note, “Monetary conditions are already more accommodative than during the last easing cycle in 2015/2016. The recently announced policy initiatives on infrastructure, housing, and automobile sectors also resemble policy supports that led to a V-shaped economic recovery in 2016.” Fed Cuts Rates To Reduce Uncertainty The economic pressure arising from a strong USD is particularly acute for EM economies. Even before the COVID-19 outbreak in China at the end of last year, global economic policy uncertainty (GEPU) and the broad trade-weighted USD (USD TWIB) were hitting new highs. This was driven by trade wars, the emergence of left- and right-wing populists globally, uncertainty over the effectiveness of monetary policy, and a host of other issues that drove investors, firms and households to seek safe-haven assets like the dollar (Chart 4). In fact, these variables became highly correlated over the past 3-, 4- and 5-year intervals.3 The novel coronavirus outbreak in China, which literally shut down China’s economy in January and February, added to this uncertainty. It continues to lurk in the background now that the coronavirus has spread globally. This also contributes to safe-haven USD demand. While a rate cut cannot address the COVID-19 directly, it can loosen financial conditions – thus removing some uncertainty at the margin – and reduce USD strength. The economic pressure arising from a strong USD is particularly acute for EM economies, which are the dominant source of commodity demand growth globally (Chart 5). At the margin, this demand for dollars arising from increased global policy uncertainty suppresses oil demand growth in EM economies, by raising its cost in local-currency terms ex-US and ex-GCC producing states with currencies pegged to the dollar. It also incentivizes production at the margin, as local-currency costs are depressed, which reduces local costs, while revenues are realized in USD – the perfect arb. Chart 4Global Uncertainty Was High Before COVID-19 Hit Markets Chart 5EM Growth Suppressed By Strong USD Exploring The Dominant Currency Paradigm The USD’s dominance of global trade is receiving considerable attention in academia and at the Fed. The USD’s dominance of global trade is receiving considerable attention in academia and at the Fed. One theory we find useful is the “Dominant Currency Paradigm,” which holds the dollar is the dominant currency in the world and is used disproportionally vis-à-vis its GDP weight in the global economy (Chart 6). Its dominance is reflected in (1) invoicing of international trade, (2) bank funding, (3) corporate borrowing, (4) central-bank reserve holdings, and (5) the relatively low expected returns accruing to USD-denominated risk-free assets that violate uncovered interest-rate parity no-arbitrage conditions – i.e., the dollar’s so-called “exorbitant privilege.”4 Chart 6USD Is The Dominant EM Invoicing Currency Demand for USD rises when global economic policy uncertainty rises, which is why dollar liquidity is crucial: When demand for safe asset spikes, there is a need for aggressive liquidity (supply) of dollar to avoid a market collapse (Chart 7).5 By cutting US rates now, the Fed is effectively increasing USD supply and/or removing some of the demand for USD relative to other currencies. This will be especially important if global economic policy uncertainty remains strong. This somewhat buffers EM corporates and governments with high levels of USD-denominated debt against a rush to safe-haven USD holdings. We believe this will ease financial conditions in EM economies, which should, all else equal, provide more of a shock absorber for uncertainty generally. Chart 7Dollar Liquidity Mutes US Dollar Appreciation   Our modeling suggests higher global economic policy uncertainty (GEPU) can shock the USD TWIB, US 10-year Treasurys and EM trade volumes directly. In addition, USD-denominated debt is relatively pronounced in some EM economies (Chart 8). USD appreciation increases domestic banks’ liabilities vs. assets. This is negative for bank’s balance sheets and leads to a tightening in financial conditions, which limits growth. EM corporate bond issuers are exquisitely sensitive to USD movements as they affect their capacity to service foreign-currency debt. Chart 8A Strong US Dollar Hurts Vulnerable EM Economies It is important to remember the US economy continues to perform relatively strongly against other major economies, with 1Q20 US GDP growth estimated by the Atlanta Fed’s Nowcast at 2.7% p.a. The fact that the Fed surprised markets with a 50bp rate cut suggests to us it is concerned with EM growth slowing sharply if the coronavirus becomes a global threat. The Fed also is likely to be concerned that lower US consumer confidence will lead to a decrease in the velocity of money. This concern also is addressed by increasing money supply pre-emptively. Our modeling suggests higher global economic policy uncertainty (GEPU) can shock the USD TWIB, US 10-year Treasurys and EM trade volumes directly, and that these shocks can persist (Chart 9).6 The Fed's policy action today will, if our modeling is correct, reduce demand for USD as a safe haven, all else equal, reduce long-term US rates and boost EM trade volumes. Bottom Line: We expect OPEC 2.0 to deliver at least 1mm b/d of production cuts in 2Q20, which will be reviewed at the end of June to determine whether they should be extended or deepened. Global economic policy uncertainty remains high, supporting demand for the USD. We believe the Fed’s surprise rate cut this week was directed at alleviating some of the global uncertainty keeping the USD well bid, in an attempt to buffer EM economies affected by USD demand. It also is a safeguard against a collapse in the velocity of money in the US that could occur if uncertainty were to suddenly rise. Chart 9GEPU Shocks Are Transmitted To USD And US Treasurys   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com   Commodities Round-Up Energy: Overweight The EIA’s weekly inventory report gives no evidence of a COVID-19-induced backup in crude and product inventories in the US. Total stocks of crude and products fell almost 12mm barrels last week on the back of strong product draws, led by gasoline and distillates, both of which were down close to 5mm barrels on the week. Commercial crude oil inventories were mostly unchanged at ~ 445mm barrels. Crude oil exports rose almost 500k b/d last week to 4.15mm b/d, accounting for most of the 9.73mm b/d of crude and product exports from the US. (Chart 10). Base Metals: Neutral Expectations China will deploy aggressive stimulus targeting infrastructure and manufacturing activities in response to the COVID-19 outbreak, along with Brazil reporting a 15% month-on-month decline in exports of iron ore helped iron ore and steel futures post significant gains earlier this week, with the Singapore Exchange's 62% Fe Iron Ore futures closing 5.6% higher on Monday. However, these gains were short-lived – and will remain capped in the short-term – as weak Chinese demand persists and steel rebar inventories remain at record highs. Precious Metals: Neutral Amid a broader market sell-off gold prices dipped 4.5% on Friday – the worst performance since 2013 – but have since recovered, on the back of the Fed’s surprise rate cut this week. The US central bank delivered an emergency 50bps rate cut on Tuesday, gold erased all the losses with spot prices rising 3.2% at the close, to reach $1645.27/oz. Silver followed a similar pattern rebounding 2.9% on Tuesday, closing at $17.22/oz. We are long both metals and believe more upside is yet to come if central banks around the world coordinate on additional monetary easing (Chart 11). Ags/Softs:  Underweight Expectations of a stronger stimulus in response to COVID-19 pushed soybeans higher for a third consecutive day on Tuesday, with prices hitting a 6-week high intraday. Bean prices then retreat and close 0.3% higher than the previous session. Gains were capped by favorable weather conditions in Brazil, leading analysts to expect a record harvest this season. Wheat also rebounded on the Fed’s rate-cut news after a sluggish week that saw prices falling almost 5%. Uncertainty still reigns though, as the Australian Bureau of Agriculture crop report predicts wheat output to recover 41% to 21.4 Mn Mt in 2020, due to rainfall ending a period of severe drought. The most active wheat futures were up 0.8% at Tuesday’s close. Chart 10US Crude Oil Exports Are Rising Chart 11Lower Real Rates Will Support Gold       Footnotes 1     We do not rule out the possibility KSA or the GCC core producers shoulder the lion’s share of the cuts they seek, in order to balance the market. 2     Please see China: Back To Its Old Economic Playbook? published by BCA Research’s China Investment Strategy February 26, 2020. It is available as cis.bcaresearch.com. 3    This heightened uncertainty – i.e., the increase in “unknown unknowns” markets are attempting to process – is a recurrent theme in our research. See, e.g., 2020 Key Views: Policy Uncertainty Continues To Drive Commodity Markets published December 19, 2019. It is available at ces.bcaresearch.com. 4    Please see Gopinath, Gita and Jeremy Stein. “Banking, Trade, and the Making of a Dominant Currency,” Working Paper currently under revision for the Quarterly Journal of Economics. 5    Gopinath (2016) finds that the dollar’s share as an invoicing currency for imported goods is approximately 4.7 times the share of U.S. goods in imports. Please see Gopinath, Gita. “The International Price System.” Jackson Hole Symposium Proceedings, published in January 2016. See also Obstfeld, Maurice (2019), “Global Dimensions of U.S. Monetary Policy,” presented at the Federal Reserve Board Conference on Monetary Policy Strategy, Tools, and Communication Practices (A Fed Listens Event) in Washington June 4, 2019. 6    Our results reflect the vector autoregression (VAR) model we use to study the interaction of GEPU shocks and the USD TWIB and US 10-year treasurys.   Investment Views and Themes Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q4 Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Closed Trades