Australia

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

Highlights Dear Client, This is the final Global Fixed Income Strategy report for 2018. We will return with our first report of the new year on January 8th, 2019. Our entire team wishes you a very happy holiday season and a prosperous new year. Best regards, Rob Robis, Chief Strategist 2019 Model Bond Portfolio Positioning: Translating our 2019 key global fixed income views into recommended overall positioning within our model bond portfolio yields the following: target a modest level of active portfolio risk, with below-benchmark duration and only neutral exposure to corporate credit. Country Allocation: Government bond allocation should continue to reflect relative expectations for monetary policy changes. That means an overweight in countries where central banks will have little scope to increase rates (core Europe, Japan, the U.K., Australia, New Zealand) and an underweight where central banks are likely to tighten more than markets currently discount (U.S., Canada, Sweden). Corporate Credit: We currently prefer U.S. corporate bonds to European and EM equivalents based on better U.S. profit prospects, which enhances debt serviceability. However, we will look to pare U.S. exposure as the Fed shifts to a more restrictive stance later in 2019. Feature Last week, we published our 2019 “Key Views” report, outlining the thematic implications of the 2019 BCA Outlook for global bond markets.1 In this follow-up report, we translate those themes into specific investment recommendations for next year. We also recommend changes to the allocations in the Global Fixed Income Strategy model bond portfolio to reflect our 2019 themes. The main takeaway is that 2019 will be another year of poor returns, with increased volatility, for most global fixed income markets. The greater pressures should come in the latter half of the year, after the U.S. Federal Reserve delivers additional rate hikes and decisive signs of a slowing U.S. economy unfold. Investors should maintain a defensive strategic posture on fixed income markets throughout the year, both for interest rate duration and credit exposure. Selling into market rallies, rather than chasing them, will prove to be the prudent strategy. Top-Down Bond Market Implications Of Our Key Views As a reminder, the main fixed income investment themes from last week’s Key Views report were the following: Late-cycle pressures will keep bond yields elevated. Global growth will remain above trend in 2019, keeping unemployment rates low and preventing central banks from turning dovish. The unwind of crisis-era global monetary policies will continue. Slowing central bank asset purchases will worsen the supply/demand balance for both government bonds, resulting in gentle upward pressure on yields via higher term premia. It is too early to worry about inverted yield curves. The time to be concerned about the recessionary implications of an inverted U.S. Treasury curve will come after the Fed has lifted real interest rates to above neutral (R*), which should occur in the latter half of 2019. Expect poor corporate bond returns from an aging credit cycle. While default risk is likely to stay modest in 2019, the greater risk for corporates could come from concerns over future credit downgrades, as well as diminished inflows in a “post-QE” world. We now present the specific fixed income investment recommendations that flow from those themes in the following categories: overall portfolio risk, overall duration exposure, country allocations within government bonds, yield curve allocations within countries, and corporate credit allocations by country and credit rating. Overall Portfolio Risk: DEFENSIVE Government bond yields enter 2019 at very low (i.e. expensive) levels across the major developed markets, even after the cumulative rise in U.S. Treasury yields seen over the past twelve months. Real yields remain below trend real GDP growth rates, a consequence of central banks keeping policy rates below neutral levels as measured by concepts like the Taylor Rule (Chart of the Week). In addition, credit spreads remain near the low end of long-run historical ranges in all markets. Without the initial starting point of cheap valuations, fixed income return expectations in 2019 should be severely tempered (Charts 2& 3). Chart 1   Chart 2Low Yields = Low Expected Returns For U.S. Corporates … Low Yields = Low Expected Returns For U.S. Corporates... Low Yields = Low Expected Returns For U.S. Corporates...   Chart 3… And European Corporates ...and European Corporates ...and European Corporates Volatility measures like the VIX index will remain elevated until markets begin to sniff out a bottoming of global growth. Much will depend on developments in China, but our expectation is that policymakers there will only act to stabilize the economy rather than provide large, 2016-scale stimulus. That may be enough to create a tactical “risk-on” trading opportunity by mid-year but we recommend using any such rally to reduce credit exposure given the risk of a more lasting global economic downturn in 2020. Importantly, cross-asset correlations should continue to drift lower without broad support from coordinated global economic growth or expanding monetary liquidity via central bank asset purchases (Chart 4). Without those rising tides lifting all boats, more active security selection by country, sector and credit rating should help portfolio managers outperform their benchmarks in what is likely to be another down year for absolute returns. Chart 4High Volatilities With Low Correlations High Volatilities With Low Correlations High Volatilities With Low Correlations That combination of diminished return prospects and elevated volatility means investors should maintain a defensive bias in fixed income portfolios heading into 2019. Within our own GFIS recommended model bond portfolio, this means keeping our tracking error (the relative expected volatility versus our custom benchmark performance index) well below our maximum target level of 100bps (Chart 5). Chart 5Maintain Moderate Overall Portfolio Risk Maintain Moderate Overall Portfolio Risk Maintain Moderate Overall Portfolio Risk Overall Duration Stance: BELOW BENCHMARK We do not think that global bond yields have peaked for this business cycle. The current period of softening global economic momentum will not turn into a prolonged period of sub-trend growth that would push up unemployment rates in the major developed economies. With the global output gap nearly closed, and monetary policymakers firmly believing in the Phillips Curve framework (lower unemployment leads to higher inflation) to forecast inflation, a more dovish stance from the major central banks seems unlikely. As we discussed in last week’s report, global bond yields are in a process of normalization away from the depressed levels seen after the 2008-09 global financial crisis and recession (Chart 6). Term premia, inflation expectations and real yields all have upside potential as central banks slowly back away from quantitative easing and low interest rate policies. Thus, we continue to recommend a defensive, below-benchmark strategic stance on overall portfolio duration exposure (Chart 7). Chart 6Bond Yields Will Continue To Normalize In 2019 Bond Yields Will Continue To Normalize In 2019 Bond Yields Will Continue To Normalize In 2019   Chart 7Stay Below-Benchmark On Duration Risk Stay Below-Benchmark On Duration Risk Stay Below-Benchmark On Duration Risk Government Bond Country Allocation: Underweight U.S., Canada, Sweden, Italy. Overweight Germany, France, U.K., Japan, Australia, New Zealand At the country level, we recommend underweighting government bond markets where central banks will be more likely to raise interest rates (because of firm domestic economic growth and building inflation pressures), but where too few rate hikes are currently discounted in money market yield curves. The U.S., Canada and Sweden fit that description (Chart 8). The U.K. would also be part of this group, but the Brexit uncertainty leads us to maintain an overweight stance on U.K. Gilts entering 2019. Chart 8Monetary Policy Expectations Drive Country Allocations Monetary Policy Expectations Drive Country Allocations Monetary Policy Expectations Drive Country Allocations By the same token, we are recommending overweights in countries where rate hikes are unlikely to occur in 2019 because of underwhelming inflation, like core Europe, Japan and New Zealand. We are currently overweight Australian government bonds, but we expect to cut that exposure in 2019 as pressure builds for a rate hike in the latter half of the year as inflation picks up. Italian government bonds represent a special case of a developed market trading off sovereign credit risk rather than interest rate or inflation risk. We continue to treat Italian government bonds the same way we view corporate debt, as a growth-sensitive asset. On that basis, we will remain underweight Italian government bonds until Italy’s leading economic indicator bottoms out, mollifying concerns about debt sustainability. The Fed is still the one central bank that is most likely to hike rates multiple times in 2019, which will sustain wide differentials between Treasuries and non-U.S. bond yields (Chart 9). Chart 9ECB, BoE, BoJ Resisting Pressure From Tight Labor Markets ECB, BoE, BoJ Resisting Pressure From Tight Labor Markets ECB, BoE, BoJ Resisting Pressure From Tight Labor Markets The greatest potential for spread widening will be for Treasuries versus JGBs, with no changes in the Bank of Japan’s monetary policy expected due to stubbornly low inflation. The 10-year Treasury-Gilt spread could also widen if the Bank of England stays on the sidelines for longer until Brexit uncertainty is resolved. The 10-year U.S.-New Zealand spread should also widen with the Reserve Bank of New Zealand staying on hold for a while due to underwhelming growth and inflation momentum. The U.S.-Canada spread will be rangebound, with the Bank of Canada likely to match, but not exceed, Fed tightening in 2019. There are some markets, though, where yields could rise a bit more than Treasury yields due to shifting monetary policies. While the ECB will refrain from raising rates next year, there is a potential for the U.S. Treasury-German Bund spread to narrow marginally if the end of ECB new asset purchases lifts Bund yields via a recovery in the German term premium. There is more (albeit still modest) scope for a narrowing in the 10-year U.S.-Australia and U.S.-Sweden spreads. After keeping monetary policy very loose for a long time, the beginning of rate hikes next year by the Reserve Bank of Australia and Riksbank could put meaningful upward pressure on deeply depressed longer-maturity Australian and Swedish yields. Yield Curve Positioning: Favor Bearish Steepeners Everywhere In The First Half Of 2019, Then Switch To Bearish Flatteners In The U.S., Canada, Australia And Sweden We expect some bearish steepening pressures to appear in most countries in the first quarter of 2019 with inflation breakevens likely to rebound if the bullish oil forecast of BCA’s Commodity & Energy Strategy team comes to fruition (Charts 10 & 11). The end of the net new buying phase of the ECB’s Asset Purchase Program in January will also put upward pressure on longer-dated European yields through a worsening supply/demand balance for European government bonds and a wider term premium, helping keep European yield curves steep. Chart 10Inflation Expectations & Bond Yields Will Rebound In 2019 … Inflation Expectations & Bond Yields Will Rebound In 2019... Inflation Expectations & Bond Yields Will Rebound In 2019...   Chart 11… As BCA’s Bullish Oil View Comes To Fruition ...As BCA's Bullish Oil View Comes To Fruition ...As BCA's Bullish Oil View Comes To Fruition Importantly, it is too soon to worry about an inversion of the U.S. Treasury curve, as we discussed in last week’s report, with the fed funds rate not yet at a restrictive level (i.e. real rates above measures of neutral like R-star). That outcome should occur by the end of 2019, when we expect the Treasury curve to move towards a true monetary policy-induced inversion. Similar patterns – steepening first from rising inflation expectations, flattening later from more hawkish central banks delivering rate hikes – should unfold in Canada, Australia and Sweden. Applying Our Global Golden Rule To Government Bond Allocations Back in September, we published a Special Report introducing a government bond return forecasting methodology called the “Global Golden Rule.”2 This is an extension of a framework introduced by our sister service, U.S. Bond Strategy, that links U.S. Treasury returns to changes in the fed funds rate that are not discounted in money markets (using our 12-month Discounters derived from Overnight Index Swap curves). In Table 1, we show the expected returns generated by the Global Golden Rule (shown hedged into U.S. dollars) for the countries in our model bond portfolio custom benchmark, based on monetary policy scenarios that we deem to be most plausible for 2019. In Table 2, we show the returns on a duration-adjusted basis (expected total return divided by duration). We then rank the return scenarios for overall country indices, aggregating the returns of the individual yield curve maturity buckets shown in those two tables, in Table 3. Table 1Global Golden Rule Return Forecasts For 2019 2019 Key Views, Part II: Time To Play Defense 2019 Key Views, Part II: Time To Play Defense   Table 2Global Golden Rule Duration-Adjusted Return Forecasts For 2019 2019 Key Views, Part II: Time To Play Defense 2019 Key Views, Part II: Time To Play Defense The shaded cells in Table 3 represent our base case forecasts for policy rate changes in each country. On this basis, the better return prospects for 2019 will be in markets where central banks will stand pat throughout the year (Germany, Japan). Conversely, the weaker returns will occur where we expect more rate hikes than currently discounted by markets (U.S., Canada). These returns fit with our recommended country allocation outlined above. Table 3Ranking The 2019 Return Scenarios 2019 Key Views, Part II: Time To Play Defense 2019 Key Views, Part II: Time To Play Defense Corporate Credit Allocation: Neutral Overall, But Overweight In U.S. Investment Grade And High-Yield Relative To European And Emerging Market Equivalents. Look To Cut The U.S. To Underweight In The Latter Half Of 2019. We enter 2019 maintaining our recommended overall neutral exposure to corporate debt. As discussed earlier, we expect to see some stabilization of global growth in the first half of 2019. This will create a playable “risk-on” rally for growth sensitive assets like corporates, but we anticipate selling into that rally by downgrading our recommended U.S. credit allocations to underweight. Within U.S. credit markets, we are recommending a less aggressive medium-term stance, staying up in quality within investment grade debt (single-B and single-A rated names versus BBBs) and high-yield (BB-rated vs CCC-rated). With 50% of the investment grade benchmark index now rated just above junk, there is a growing risk of “fallen angel” downgrades to junk status in the event of a material slowing of U.S. economic growth. At the same time, default-adjusted spreads on U.S. high-yield debt only appear attractive if the current exceptionally low default rate backdrop persists (Chart 12). In other words, both U.S. investment grade and high-yield corporate debt are vulnerable to any major slowing of U.S. economic growth and slump in corporate profits. Chart 12U.S. Corporates Vulnerable To Slower Growth U.S. Corporates Vulnerable To Slower Growth U.S. Corporates Vulnerable To Slower Growth The confluence of above-trend U.S. growth and still pro-cyclical Fed policy will support U.S. credit in the near-term, but that will all change later in 2019. We expect the Fed to deliver at least 75bps of rate hikes in 2019 – perhaps only pausing from the current 25bps per quarter pace at the March meeting – which will push the funds rate into restrictive territory and invert the Treasury curve sometime in the 4th quarter of the year. This will cause investors to start to discount a deep growth slowdown in 2020, which will trigger systemic credit spread widening (Chart 13). We expect our next move on U.S. corporate debt to be a downgrade to underweight, likely sometime around mid-year. Chart 13Growth Differentials Continue To Favor U.S. Growth Differentials Continue To Favor U.S. Growth Differentials Continue To Favor U.S. We still prefer U.S. corporates to European or Emerging Market (EM) equivalents, however, thanks to the likelihood of better near-term growth prospects in the U.S. We are concerned about how the European corporate bond market will perform without the support of ECB asset purchases, which leads us to underweight both investment grade and high-yield European corporates (Chart 14).3 Chart 14Stay Overweight U.S. Corporates Vs European Corporates Stay Overweight U.S. Corporates Vs European Corporates Stay Overweight U.S. Corporates Vs European Corporates EM corporates will continue to suffer from the toxic combination of rising U.S. interest rates, a stronger dollar and global growth concerns. Our political strategists remain skeptical on the prospects for a permanent deal on thorny U.S.-China trade issues, leaving EM assets exposed to slowing momentum in China’s economy. We continue to prefer owning U.S. credit, given how the relative performance of EM and U.S. credit has not yet converged to levels implied by U.S./EM growth differentials (Chart 15). Chart 15Stay Overweight U.S. Corporates Vs EM Corporates Stay Overweight U.S. Corporates Vs EM Corporates Stay Overweight U.S. Corporates Vs EM Corporates Model Portfolio Adjustments To Begin 2019 In terms of our model bond portfolio, we recommend a few changes to our current allocations to reflect our 2019 outlook and key views (see the table below). We make a few adjustments to our individual country duration allocations, given our expectations of some re-steepening of global yield curves. We also bump up our allocation to core European debt given our expectation that the ECB will keep policy rates on hold throughout 2019. We fund that increase in European exposure from U.S. Treasuries, where too few Fed rate hikes are now discounted. Finally, we make a modest adjustment to our U.S. high-yield allocations, cutting CCC-rated exposure and upgrading B-rated credit.   Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com   Footnotes 1 Please see BCA Global Fixed Income Strategy Weekly Report, “2019 Key Views: Normalization Is The “New Normal””, dated December 12th 2018, available at gfis.bcarsearch.com. 2 Please see BCA Global Fixed Income Strategy Special Report, “The Global Golden Rule Of Bond Investing”, dated September 25th 2018, available at gfis.bcaresearch.com. 3 Please see BCA Global Fixed Income Strategy Weekly Report, “Stubbornly Resilient Bond Yields”, dated November 13th 2018, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index 2019 Key Views, Part II: Time To Play Defense 2019 Key Views, Part II: Time To Play Defense Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights The dollar will continue to rally despite the trade truce agreed upon last weekend between U.S. President Donald Trump and China President Xi Jinping. Not only is this truce far from a permanent deal, but global growth continues to slow. Moreover, if the truce were to generate a genuine improvement in global growth conditions, this would likely result in a much more hawkish Federal Reserve than the market is currently pricing in. This would lead to a further deterioration in global liquidity conditions, causing additional growth problems for the world. Buy EUR/CHF, as the Swiss National Bank will soon have to intervene in the market. Sell AUD/NOK, as oil should outperform metals and the Norges Bank is better placed to tighten policy than the Reserve Bank of Australia. Feature Presidents Donald Trump and Xi Jinping have agreed to freeze additional new tariffs on Chinese exports to the U.S. for three months. This means that as of January 1, 2019, U.S. tariffs on US$200 billion of Chinese exports to the U.S. will remain at 10%, and will not jump to 25%. Meanwhile, China has agreed to immediately resume its imports of soybeans and LNG from the U.S. Moreover, China has also agreed to begin talks to open up Chinese markets to U.S. exports as well as to address U.S. worries regarding intellectual property theft. The world has let out a collective sigh of relief. A potent narrative exists that fears of a trade war have been the root cause of the slowdown in global growth witnessed this year. Consequently, since the dollar performs well when global industrial activity slows, this also means that ending the trade war could be key to abort the dollar’s bull market. We are doubtful this narrative will pan out, and we do not think that the Buenos Aires truce will lead to the end of the dollar rally. This also means that the G-20 armistice is also unlikely to reverse the underperformance of commodity and Scandinavian currencies. First, this truce does not mark the end of the trade war. It is only an agreement to delay the implementation of U.S. tariffs. Come March, the Trump administration may well sing a very different tune. The U.S. domestic political climate has not changed one iota, and protectionism, particularly when directed at China, still wins votes (Chart I-1). Meanwhile, the concessions China is willing to give are long-term in nature; however, Trump wants visible wins well ahead of the 2020 elections. This mismatch creates a real danger that the White House imposes new tariffs again beyond the three-month armistice agreed at the G-20. The news yesterday afternoon that the CFO of Huawei was indicted in Vancouver already casts doubts on the deal. Chart I-1Americans Will Remain Tough On China Waiting For A Real Deal Waiting For A Real Deal Second, the dollar has been strong, and risk assets have been weak for more reasons than the trade war alone. As shown by the slowdown in Japanese or Taiwanese exports, as well as by the contraction in German foreign orders and in the CRB Raw Industrial Index’s inflation, global trade and global growth are slowing (Chart I-2). This development is likely to last until mid-2019, as our global leading economic indicator continues to fall. This deterioration in the global LEI does not look set to stop soon, as normally any improvement in the global LEI is first telegraphed by a stabilization in the Global LEI Diffusion Index – an indicator that is still falling (Chart I-3). Chart I-2Global Growth Continues To Slow Global Growth Continues To Slow Global Growth Continues To Slow Chart I-3No Bottom In Sight For The Global LEI No Bottom In Sight For The Global LEI No Bottom In Sight For The Global LEI China is not yet coming to the rescue either. The slowdown in Chinese economic activity continues, and in fact, the paucity of a rebound in Chinese credit growth despite injections of liquidity by Beijing suggests that a bottom is not yet in sight (Chart I-4). Hopes that were raised by increased bond issuance from local governments have also been dashed as this proved to be a very temporary phenomenon (Chart I-5). What is more worrisome is that so far Chinese exports have held their ground; however, the decline in the new export orders of the Chinese PMI suggests that this support to growth is likely to taper sharply in the coming months (Chart I-6). Chart I-4Credit Growth Decelerating Despite Stimulus Credit Growth Decelerating Despite Stimulus Credit Growth Decelerating Despite Stimulus   Chart I-5Chinese Infrastructure Push Looks Transitory Waiting For A Real Deal Waiting For A Real Deal   Chart I-6Chinese Exports: The Last Shoe To Drop Chinese Exports: The Last Shoe To Drop Chinese Exports: The Last Shoe To Drop Finally, despite the cloudy outlook for global growth that built up this year, U.S. yields had risen 80 basis points by November 8, adding stress to economies already negatively impacted by weakening manufacturing activity. This increase in global borrowing costs has worsened the already noticeable decline in U.S.-dollar based liquidity (Chart I-7). This decline in liquidity has been a great source of concern as EM economies, the source of marginal growth in the global economy, have large dollar-denominated debt loads, and thus need abundant dollar liquidity in order to support their economies (Chart I-8). Chart I-7Slowing Dollar Liquidity Explains Weak Global Growth... Slowing Dollar Liquidity Explains Weak Global Growth... Slowing Dollar Liquidity Explains Weak Global Growth... Chart I-8...Because There Is A Lot Of Dollar Debt Where Growth Is Generated ...Because There Is A Lot Of Dollar Debt Where Growth Is Generated ...Because There Is A Lot Of Dollar Debt Where Growth Is Generated This last point is especially unlikely to change in response to the Buenos Aires truce. Since November, 10-year U.S. yields have fallen around 25 basis points, and now fed funds rate futures are only pricing in 45 basis points of rate hikes over the coming two years, including the December hike. If business sentiment improves because of a trade truce, and consequently U.S. capex proves more resilient than anticipated by market participants, the Federal Reserve will increase rates by much more than what is currently priced into the futures curve (Chart I-9). Chart I-9U.S. Rates Have Plenty Of Upside, Even More So If The Trade Truce Becomes A Peace Treaty Waiting For A Real Deal Waiting For A Real Deal This will lift yields, resuscitating one of the first reasons why markets have been weak this fall. This risk is even greater than the market appreciates. After Fed Chair Jerome Powell gave what was perceived as a dovish speech last week, markets were further emboldened to bet on a Fed pause. However, Fed Vice-Chairman Richard Clarida and New York Fed President John Williams have both argued since that the U.S. economy will continue to run above trend and warrants further gradual increases in interest rates. A truce in Buenos Aires may only provide them with more ammunition to implement those hikes. Global liquidity conditions are unlikely to improve significantly anytime soon. Moreover, the truce could also change the calculus in Beijing. Much of the stimulus implemented since last summer in China has been to limit the negative impact of a trade war. However, if a trade war is not in the cards, Beijing has fewer reasons to abandon its deleveraging campaign. It thus raises the possibility that with a risk to China evaporating, the Xi Jinping administration would instead not do anything to limit the slowdown in credit. This implies that Chinese capex would stay weak and that China’s intake of raw materials and machinery would not pick up. This means that the euro area and countries like Australia will continue to lag behind the U.S.  Ultimately, the market speaks louder than anything else. The incapacity for risk assets to catch a bid in the wake of what was good news is disconcerting. It suggests that the combined assault of slowing global growth and a tightening Fed remains the main problem for global financial markets. Hence, in this kind of deflationary environment, the dollar reign supreme – even if U.S. growth were to slow (Chart I-10). Chart I-10A Strong Dollar Is Not A Function Of Strong U.S. Growth A Strong Dollar Is Not A Function Of Strong U.S. Growth A Strong Dollar Is Not A Function Of Strong U.S. Growth Bottom Line: A trade truce in Buenos Aires could have aborted the bull market in the dollar. So far, it has not, and we do not think it will be able to end the dollar’s rally. First, this truce remains flimsy, and does not guarantee an end of the trade war between China and the U.S. Second, global growth continues to exhibit downside. Finally, the Fed is unlikely to change its course and pause its hiking campaign. In fact, if a trade truce is so good for trade, it will give more reasons for the Fed to hike and may even incentivize Chinese authorities to abandon their efforts to cushion the Chinese economy against slowing global trade. Stay long the dollar and keep a defensive exposure in the FX market, one that favors the yen and the greenback at the expense of Scandinavian and commodity currencies. Buy EUR/CHF Despite our view that global growth is set to slow, we are inclined to buy EUR/CHF this week. We expect the Swiss National Bank to stop sitting on its hands as a stronger CHF is becoming too painful. First, as we highlighted last week, aggregate Swiss economic activity is slowing sharply.1 What is more concerning is that consumer spending is also suffering, as shown by the contraction in real retail sales (Chart I-11). This implies that despite record-low interest rates, Swiss households are feeling the pinch of the tightening in Swiss monetary conditions created by the stronger CHF. Chart I-11Swiss Households Are Feeling The Pinch Swiss Households Are Feeling The Pinch Swiss Households Are Feeling The Pinch Second, the franc remains a problem for Swiss competitiveness. As Chart I-12 shows, Swiss labor costs are completely out of line with its competitors. This phenomenon worsened significantly after 2008 due to the Franc’s strength vis-à-vis the euro. Despite the weakness in the franc from mid-January 2015 to April 2018, Swiss unit labor costs remain uncompetitive. This means that going forward, either the SNB will have to tolerate a further contraction in wages, something unpalatable as Swiss households have a debt load equal to 212% of disposable income, or the franc will have to fall. Chart I-12The CHF Makes Switzerland Uncompetitive The CHF Makes Switzerland Uncompetitive The CHF Makes Switzerland Uncompetitive Third, the franc’s recent strength is only accentuating the deflationary impact of softer global growth on the local economy. As Chart I-13 illustrates, the recent strengthening in the trade-weighted CHF portends to a potentially painful contraction in import prices, while core inflation is already well off the SNB’s 2% objective. Moreover, as the second panel of Chart I-13 shows, our CPI model suggests that Swiss inflation is about to fall into negative territory again. This would imply that not only will the Swiss economy suffer from the recent strengthening in the franc, but also that Swiss real interest rates are about to increase by 100 basis points, the last thing a slowing economy needs. Chart I-13Swiss Deflation Will Return Swiss Deflation Will Return Swiss Deflation Will Return This economic backdrop suggests to us that after 16 months where the SNB played nearly no active role in managing the CHF exchange rate, the Swiss central bank is about to come back to the market in order to limit the downside in EUR/CHF. This makes buying this cross attractive, as it offers a favorable asymmetric payoff. EUR/CHF generates a small positive carry, has limited downside and offers ample upside if the SNB intervenes – all while offering low volatility. Meanwhile, if global growth picks up, EUR/CHF should also rebound. In fact, the pro-cyclical behavior of EUR/CHF, as well as its asymmetric payoff, increases the attractiveness of this trade within our broadly defensive portfolio stance: It hedges us against being wrong on the global growth outlook and the importance of the trade truce. Furthermore, any resolution to Italy’s battle with Brussels will also boost this cross. Bottom Line: EUR/CHF normally depreciates when global growth slows. While this pattern materialized in 2018, we anticipate EUR/CHF to stabilize and potentially rally, even if global growth slows. The strong CHF is now causing serious pain to the Swiss economy, and the SNB will have to prevent any deepening of the malaise. The SNB is thus set to begin intervening in the market. Additionally, if we are wrong and global growth does not slow further, being long EUR/CHF provides a hedge to our defensive market stance. AUD/NOK To Be Knocked Down An attractive opportunity to sell AUD/NOK has emerged. First, on the back of the weakness in oil prices relative to metals prices, AUD/NOK has caught a furious bid in recent weeks (Chart I-14). However, we expect the underperformance of oil relative to metals to peter off. The main factor that has weighed on petroleum prices is that Saudi Arabia has kept extracting oil at full speed, expecting a shortage of oil in global markets once U.S. sanctions on Iran kicked in. Chart I-14AUD/NOK Strength: A Reflection Of Weak Crude Prices AUD/NOK Strength: A Reflection Of Weak Crude Prices AUD/NOK Strength: A Reflection Of Weak Crude Prices However, with President Trump greatly softening his stance and allowing exemptions for some countries to import Iranian oil, the crude market instead has experienced a mini unforeseen oil glut. OPEC 2.0, just agreed to essentially remedy this problem by limiting their oil output. This should boost oil prices. Meanwhile, slowing global growth centered on slowing Chinese capex will have a much deeper impact on industrial metals prices than on oil. This represents a negative terms-of-trade shock for Australia vis-à-vis Norway. Second, domestic economic conditions also favor betting on a weaker AUD/NOK. Australian nominal GDP growth often weakens when compared to Norway’s ahead of periods of depreciation in AUD/NOK. Today, Australia’s nominal GDP growth is sagging relative to Norway’s, and the contraction in Australia’s LEI relative to Norway suggests that this trend will deepen (Chart I-15). A rebound in oil prices relative to metals prices will only reinforce this process. Chart I-15Domestic Economic Conditions Point To A Lower AUD/NOK Domestic Economic Conditions Point To A Lower AUD/NOK Domestic Economic Conditions Point To A Lower AUD/NOK Third, AUD/NOK seems expensive relative to the anticipated path of policy of the Reserve Bank of Australia relative the Norges Bank (Chart I-16). Moreover, the Norwegian central bank has begun lifting rates, and since real interest rates in Norway are still negative, it will continue to tighten policy next year. Meanwhile, the RBA remains reticent to increase interest rates as Australian inflation and wage growth are still tepid. The recent deceleration in Australian GDP growth as well as budding problems in the Aussie real estate market will only further cajole the RBA in its reluctance to lift the cash rate higher. Hence, the real interest rate differentials will continue to point toward a lower AUD/NOK. Chart I-16AUD/NOK At A Premium To Expected Rates AUD/NOK At A Premium To Expected Rates AUD/NOK At A Premium To Expected Rates Fourth, AUD/NOK is once again very expensive, trading at a 12% premium to it purchasing power parity equilibrium (Chart I-17). It only traded for an extended period of time at a richer premium when Brent was free-falling to US$25/bbl. Since we anticipate oil to rebound, such a premium in AUD/NOK is unwarranted. Chart I-17AUD/NOK Is Pricey AUD/NOK Is Pricey AUD/NOK Is Pricey Finally, all our technical indicators show that AUD/NOK is massively overbought (Chart I-18). The study on momentum we conducted last year showed that out of 45 G-10 FX pairs tested, after AUD/SEK, AUD/NOK was the second worst one to implement momentum-continuation trades.2 As a result, we would anticipate that the recent period of overbought conditions will lead to a period of oversold conditions. Chart I-18The Mean-Reverting AUD/NOK Is Overbought The Mean-Reverting AUD/NOK Is Overbought The Mean-Reverting AUD/NOK Is Overbought Bottom Line: Selling AUD/NOK today makes sense. BCA anticipates oil prices to rebound relative to metals prices, the Australian economy is slowing relative to Norway’s, monetary policy is moving in a NOK-friendly fashion, AUD/NOK is expensive, and the cross is well-placed to experience a large episode of momentum reversal.   Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com  Footnotes 1 Please see Foreign Exchange Strategy Special Report, titled “2019 Key Views: The Xs And The Currency Market”, dated November 30, 2018, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Special Report, titled “Riding The Wave: Momentum Strategies In Foreign Exchange Markets”, dated December 8, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the U.S. has been mixed: The price component of the ISM manufacturing survey underperformed expectations, coming in at 60.7. This measure also declines sharply from the previous month. However, the headline ISM Manufacturing survey surprised to the upside, coming in at 59.3. Total vehicle sales also outperformed expectations, coming in at 17.50 million. The DXY U.S. dollar Index was flat for the past two weeks. We continue to be bullish on the U.S. dollar. The current environment of falling global growth and falling inflation has historically been very positive for this currency. Moreover, the fed will likely hike more than anticipated by the market, providing another tailwind for the dollar until at least the first quarter of 2019. Report Links: 2019 Key Views: The Xs And The Currency Market - December 7, 2018 Six Questions From The Road - November 16, 2018 Updating Our Intermediate Timing Models - November 2, 2018 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data in Europe has been mixed: Retail sales growth underperformed expectations, coming in at 1.7%. Moreover, core inflation also surprised to the downside, coming in at 1%. However, market services and composite PMI surprised positively, coming in at 53.4 and 52.7 respectively. EUR/USD has been flat for the past two weeks. We are bearish on the euro, given that we expect Chinese tightening to continue to weigh on global growth. Furthermore, recent disappointment in euro area inflation confirms our view that it will be very difficult for the ECB to tighten policy. This means that rate differentials will continue to move against EUR/USD. Report Links: 2019 Key Views: The Xs And The Currency Market - December 7, 2018 Six Questions From The Road - November 16, 2018 Evaluating The ECB’s Options In December - November 6, 2018 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan has been mixed: The Nikkei manufacturing PMI outperformed expectations, coming in at 52.2. Moreover, housing starts yearly growth came in line with expectations, at 0.3%. However, Markit Services PMI came in at 52.3, decreasing from last month’s number. USD/JPY has decreased by -0.4% these past two weeks. We are positive on the yen for the first quarter of 2019. The current risk off environment should be positive for safe havens like the yen. We are particularly negative on EUR/JPY, as this cross is very well correlated with bond yields, which should keep decreasing as markets continue to sell off. Report Links: 2019 Key Views: The Xs And The Currency Market - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Will Rising Wages Cause An Imminent Change In Policy Direction In Europe And Japan? - October 5, 2018 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. has been mixed: Nationwide housing prices yearly growth came in at 1.9%, outperforming expectations. Moreover, Markit manufacturing PMI as well as construction PMI both surprised positively, coming in at 53.1 and 53.4 respectively. However, Markit Services PMI underperformed expectations, coming in at 50.4. GBP/USD has decreased by 0.7% these past two weeks. The pound continues to be a complex currency to forecast. While the pound is cheap and makes for a potentially attractive long-term buy, current political risk continue to make a shorter-term position very risky. Report Links: Six Questions From The Road - November 16, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia has been negative: Gross domestic product yearly growth underperformed expectations, coming in at 2.8%. Moreover, building permits month-on-month growth also surprised negatively, coming in at -1.5%. Finally, construction done also surprised to the downside, coming in at -2.8%. AUD/USD has decreased by -0.5% these past two weeks. We believe that the AUD is the currency with the most potential downside in the G10. After all, the Australian economy is the economy in the G10 most leveraged to the Chinese industrial cycle, due to Australia’s high reliance on industrial metal exports. This means that the continued tightening by Chinese authorities should be most toxic for this currency. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Policy Divergences Are Still The Name Of The Game - August 14, 2018 What Is Good For China Doesn’t Always Help The World - June 29, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand has been mixed: Building permits month on month growth outperformed expectations, coming in at 1.5%. However, retail sales as well as retail sales ex-autos both declines from the previous quarter, coming in at 0% and 0.4%. NZD/USD has increased by 1% these past two weeks. After being bullish in the NZD for a couple of months, we have recently turned bearish, as we believe that this currency is very likely to suffer in the current environment of declining inflation and global growth. With that said, we remain bullish on the NZD relative to the AUD, given that the kiwi economy is less exposed to the Chinese industrial cycle than Australia. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 In Fall, Leaves Turn Red, The Dollar Turns Green - October 12, 2018 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data in Canada has been positive: Retail sales month on month growth outperformed expectations, coming in at 0.2%. Moreover, headline inflation also surprised to the upside, coming in at 2.4%. Finally, the BOC core inflation measure increased from last month’s number, coming in at 1.6%. USD/CAD has risen by 1.7% these past two weeks. A lot of this weakness was caused by the dovish communication of the Bank of Canada following their announcement to keep rates on hold at 1.75%. This change in stance is likely a response to the collapse in oil prices in the past months. With that in mind, we are inclined to believe that the CAD might be reaching oversold levels, as oil is likely to stabilize and the economy continue to show signs of strength. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland has been negative: Gross domestic product yearly growth underperformed expectations, coming in at 2.4%. Moreover, the KOF leading indicator also surprised to the downside, coming in at 99.1. Finally, headline inflation also surprised negatively, coming in at 0.9%. EUR/CHF has decreased by 0.5% these past two weeks. Our bullish view on EUR/CHF is a high conviction view for the first part of 2019. This is because the recent strength in the franc is choking out any inflationary pressures in the Swiss economy. Thus, we are reaching the threshold at which the SNB is very likely to intervene in the currency market to prevent the franc’s strength from derailing the path toward the inflation target. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway has been negative: Retail sales growth underperformed expectations, coming in at -0.2%. Moreover, registered unemployment also surprised negatively, coming in at 2.3%. Finally, the credit indicator came in line with expectations at 5.7%. USD/NOK has been flat these past two weeks. We are shorting AUD/NOK this week, as a way to take advantage of stabilizing oil prices and a continued growth slowdown in China. Moreover, AUD/NOK is expensive in PPP terms, and is technically overbought. Finally, this currency shows one the most mean reverting tendencies in the G10, which means that the recent surge in this cross is likely to reverse. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data in Sweden has been negative: Consumer confidence underperformed expectations, coming in at 97.5. Moreover, retail sales growth also underperformed expectations, coming in at -0.1%. Finally, gross domestic product yearly growth also surprised negatively, coming in at 1.6%. USD/SEK has fallen by roughly 1% these past two weeks. On a short-term basis, we are negative on the krona, given that this currency is very sensitive to global growth dynamics, which means that the continued tightening by both Chinese authorities and the Fed will create a headwind for any SEK rally. That being said, on a longer-term basis we are more positive on the krona, as the Riksbank continues to be too dovish given the current inflationary backdrop. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades