British Pound

Listen to a short summary of this report.     Executive Summary Sentiment On Sterling Is Depressed Sentiment On Sterling Is Depressed Sentiment On Sterling Is Depressed The pound will suffer in the short term, setting the stage for a coiled-spring rebound. Cable is extremely cheap by most measures (Feature chart). The BoE could engineer a soft landing in the UK economy. If successful, it will annihilate sterling vigilantes, in a volte-face of the ERM crisis. We are cognizant of near-term risks. As such, we are long EUR/GBP with a target of 0.90, but will be buyers of cable at 1.20. Ultimately, the pound is undervalued on a longer-term basis. GBP/USD should touch 1.36 over the next 12-18 months. RECOMMENDATIONS INCEPTION LEVEL inception date RETURN long eur/gbp 0.846 2021-10-15 0.27 Bottom Line: The pound will likely face pressure in the near term, but will fare well over a cyclical horizon. Our 12-month target is 1.36. This target is based on a modest reversion towards PPP fair value, and some erosion in the “crisis” discount. Admittedly, sentiment on the pound is very depressed, and we could be wrong in our near-term assessment and cable has indeed bottomed. Feature Chart 1A Play On Cable Downside A Play On Cable Downside A Play On Cable Downside There has been much discussion around the premise that the pound could enter a capitulation phase, akin to an emerging market-style currency crisis. With inflation sitting at 9%, well above the Bank of England’s 2% target, the narrative is that interest rates need to rise substantially but will, at the same time, kill any recovery. The result will be a sharp fall in the pound. We began to highlight the near-term risks to cable in October of last year, going long EUR/GBP in the process, as a way to play sterling downside (Chart 1). That said, our longer-term view on the pound remained positive. In this report, we review what has changed since, and if a negative longer-term view is now warranted.   UK Balance Of Payments Almost all currency crises are rooted in a deterioration of the external balance, and this is certainly true for the UK. The trade deficit sits at 7.9% of GDP, the worst among G10 countries (Chart 2). As a result, the current account is also in deficit. That said, there are reasons for optimism. Related Report  Foreign Exchange StrategyAn Update On Sterling The Office for National Statistics (ONS) suggests that a change in methodology in January 2022 could be exarcebating the deterioration in the latest release of the trade balance. In our view, there are two key reasons why the UK’s balance of trade is worsening. The first is the oil shock – fuels constitute 11% of UK imports. Second, unprecedented fiscal stimulus led to an overshoot in goods imports. These negative forces are likely cyclical in nature, rather than structural. It is also noteworthy that most of the goods imported into the UK are machinery and transport equipment, which could go a long way in improving its productive capacity (Chart 3). Chart 2The UK Trade Balance Has Deteriorated The UK Trade Balance Has Deteriorated The UK Trade Balance Has Deteriorated Chart 3Goods Imports Have Been A Hit To The UK Trade Balance Goods Imports Have Been A Hit To The UK Trade Balance Goods Imports Have Been A Hit To The UK Trade Balance In parallel, there has been a structural improvement in the UK’s current account balance. This has mostly been driven by a rising primary income balance. In short, investments abroad are earning more, relative to domestic liabilities (Chart 4). The UK runs a large negative international investment position. Despite this, it has maintained the ability to issue debt bought by foreigners, while investing in high-return assets abroad. Secondary income has admittedly been in a structural deficit, but a falloff in transfer payments under the Brexit agreement will significantly improve this balance (Chart 5). Chart 4The UK Current Account Is Improving The UK Current Account Is Improving The UK Current Account Is Improving Chart 5A Fall In Brexit Payments Will Mend Secondary Income Is Sterling Facing Another Crisis? Is Sterling Facing Another Crisis? Finally, the pound’s share of global foreign exchange turnover is 12.8%, just behind the dollar, euro, and yen. That said, London dwarfs New York, Hong Kong, and Tokyo as a hub for foreign exchange trading (Chart 6). The pound also very much remains among the most desirable global currencies. Global allocation of FX reserves in sterling have been rising over the last decade (Chart 7). It currently stand at 4.8%, higher than the RMB at 2.8%, and all other emerging market currencies combined. Chart 6London Remains An Important Financial Center Is Sterling Facing Another Crisis? Is Sterling Facing Another Crisis? Chart 7The Pound Is Still A Reserve Currency The Pound Is Still A Reserve Currency The Pound Is Still A Reserve Currency It is noteworthy to revisit the period the pound experienced an EM-style crisis – under the European Exchange Rate Mechanism (ERM), when cable was effectively pegged to the German mark at an expensive level. At the time, UK inflation was running hot, while German inflation was more subdued. By importing monetary policy from the Bundesbank, the BoE was able to tame inflation, but at a high cost to growth. In Germany, the reunification boom warranted much higher interest rates, which was not appropriate for the UK . Cable eventually collapsed by 32.9% peak-to-trough, as the UK ran out of foreign currency reserves. Chart 8Cable Is Very Cheap Cable Is Very Cheap Cable Is Very Cheap There are three key differences between that episode and today: The pound is freely floating. Foreign exchange markets are extremely fluid and adjust to expectations quite quickly. A collapse in the pound seems unlikely, unless the UK faces a new large exogenous shock. Inflation is running hot in many countries, not just the UK. The pound is extremely cheap, and stimulative for the economy. On a real effective exchange rate basis, the pound is at record lows (Chart 8).     Will The BoE Make A Policy Mistake? Sterling is pricing in a policy mistake by the BoE. First, inflation is well above its 2% target. Second, the labor market has tightened significantly. The unemployment rate hit a 47-year low of 3.7%, and job vacancies are low, pushing wages higher. As such, either the BoE allows inflation expectations to become unmoored, destroying the purchasing power of the pound, or kills the recovery to maintain credibility (Chart 9). Chart 9The UK Labor Market Is Tight The UK Labor Market Is Tight The UK Labor Market Is Tight While difficult, there are reasons to believe the BoE can achieve a soft landing. According to an in-house study, only one-third of the rise in UK inflation has been driven by demand-side pull, with the balance related to supply factors.1 The latter have been the usual suspects – rising energy costs, supply shortages, and even legacies of the Brexit shock (Chart 10). UK electricity prices have cratered since the opening of the 1,400MW undersea cable with Norway (Chart 11). Chart 10Most Of The Increase To UK Prices Is Supply-Driven Is Sterling Facing Another Crisis? Is Sterling Facing Another Crisis? Chart 11A Sharp Drop In Electricity Prices A Sharp Drop In Electricity Prices A Sharp Drop In Electricity Prices Second, it is likely that the neutral rate of interest in the UK is lower in a post-Brexit, post-COVID-19 world. This is visible in trend productivity growth, but even the size of the labor force has shrunk significantly. The UK workforce is down by 560,000 people since the start of the pandemic. This has been partly due to less immigration and more retirees, but the vast majority has been due to health side-effects from the pandemic, and delays in getting adequate medical care. As a result, there has barely been a recovery in the UK participation rate (Chart 12). Chart 12AThe Participation Rate In The UK Is Below Trend The Participation Rate In The UK Is Below Trend The Participation Rate In The UK Is Below Trend Chart 12BA Low Participation Rate Across Many Regions A Low Participation Rate Across Many Regions A Low Participation Rate Across Many Regions In hindsight, a least-regrets strategy to policy tightening – lift rates faster now, and then back off if financial conditions tighten sufficiently – seems appropriate. Frontloading the pace of tightening will flatten the UK gilts curve further. With most borrowing costs in the UK tied to the longer end of the curve, refinancing costs might not edge up that much, while inflation expectations will be well contained. The real canaries in the coal mine from this strategy are the economies of Australia, New Zealand, and Canada, where household debt is much more elevated (Chart 13), and the percentage of variable rate mortgages  are higher. Chart 13Household Debt Is Not Alarming In The UK Household Debt Is Not Alarming In The UK Household Debt Is Not Alarming In The UK Larger fiscal stimulus will partially offset the near-term hit from tighter monetary policy. The additional £15 billion cost-of-living package announced last month is quite substantial at 0.7% of GDP. This gives the BoE breathing room to tighten policy in the near term. The redistributionist nature of the plan – taxing windfall profits from large energy companies, and using that to subsidize consumers most in need – could be what is required to achieve a soft landing, if the energy shock is temporary. Our Global Fixed Income colleagues upgraded UK gilts to overweight last month, on the basis that market pricing further out the SONIA curve was too aggressive. In our prior report on sterling, we also suggested that market expectations for interest rate increases may have overshot. Money markets are discounting a peak in the bank rate at 2.8%. The BoE’s new Market Participants survey suggests it will peak at 1.75%. While the BoE will deliver sufficient monetary tightening to lean against near-term inflationary pressures, it will be very wary to overdo it. This is especially true if the neutral rate in the economy is much lower. What Next For The Pound? Our view is that the pound faces near-term risks but is a buy longer term. There is an old adage that credibility is hard to earn, but easy to lose. For the UK in particular, this hits the mark. The Bank of England is the oldest central bank in the world, after the Riksbank. Yes, the BoE can make a policy mistake (as it has in the past), but treating the pound as an emerging market asset is a stretch (Chart 14). That said, our Chief European Strategist, Mathieu Savary, believes stagflation is not fully priced into UK assets. In the near term, he might be right. The UK’s large trade deficit puts the onus on foreigners to dictate movements in the pound. The pound does well when animal spirits are fervent. So far, markets have bid up a substantial safe-haven premium into the dollar (Chart 15). As a proxy, the pound has been sold. Northern Ireland could also return as a thorn in the side of sterling.  Chart 14The Pound Is A Risk-On Currency Cable And EM Stocks The Pound Is A Risk-On Currency Cable And EM Stocks The Pound Is A Risk-On Currency Cable And EM Stocks Chart 15The Dollar Has A Hefty Safe-Haven Premium The Dollar Has A Hefty Safe-Haven Premium The Dollar Has A Hefty Safe-Haven Premium From a bird’s eye view, three factors tend to drive currencies – the macroeconomic environment, valuation, and sentiment. For now, markets have latched on to the GBP’s vulnerability to an EM-style crisis. That said, cable is very cheap, even accounting for elevated UK inflation. Our in-house PPP model suggests the pound could appreciate by 4% per year, over the next 10 years, just to revert to fair value (Chart 16). Chart 16Cable Is Cheap Cable Is Cheap Cable Is Cheap Admittedly, the UK desperately needs an improvement in productivity growth for further currency gains. To encourage capital inflows that the pound depends on, the UK needs to be at the forefront of disruptive technologies such as electric cars, digital currencies, 3D printing, and even innovations in gene therapy. High finance and fashion will remain relevant for London, but the need for innovation is high.  Investment Conclusions Chart 17Sentiment On Sterling Is Depressed Sentiment On Sterling Is Depressed Sentiment On Sterling Is Depressed The pound will likely face pressure in the near term, but will fare well over a cyclical horizon. Our 12-month target is 1.36. This target is based on a modest reversion towards PPP fair value, and some erosion in the “crisis” discount. Admittedly, sentiment on the pound is very depressed, and we could be wrong in our near-term assessment if cable has indeed bottomed. Our intermediate-term timing model suggests that GBP is undervalued and has bottomed. Technical indicators also warn that cable is ripe for a fervent rebound (Chart 17). Particularly, our intermediate-term technical indicator is rebounding from oversold levels. The Aussie would outperform the pound in the long term, but AUD/GBP is vulnerable to a commodity relapse in the shorter term.   Housekeeping We were stopped out of our short EUR/JPY trade for a loss of -2.78%, as oil prices and bond yields rebounded. This trade is a hedge to our pro-cyclical portfolio, so we will look to reenter it at more attractive levels. We are also lowering the stop-loss on our short RUB trade. This is a speculative bet many clients will not be able to play, but we expect it to payoff over the longer term.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Michael Saunders, "The route back to 2% inflation," (Speech given at the Resolution Foundation), May 9, 2022.   Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary

Executive Summary UK Stocks Are Close To A Bottom UK Stocks Are Close To A Bottom UK Stocks Are Close To A Bottom The UK economic outlook has greatly deteriorated. Weak global growth and punishing energy inflation will cause activity to contract over the next 12 months. Cost-push pressures will drag inflation above 10% in 2022. Moreover, demand-pull inflation highlights problems with the supply-side of the economy. UK yields have downside relative to those in the Euro Area. GBP/USD will bottom once global stock prices find a floor. EUR/GBP possesses more upside. UK stocks will enjoy a structural tailwind relative to their Eurozone counterparts as a result of a secular bull market in commodity prices. Nonetheless, UK equities are likely to underperform in the second half of 2022. UK small-cap stocks are massively oversold compared to large-cap shares; however, a peak in energy inflation must take place for small-cap equities to stage a rebound. TACTICAL INCEPTION DATE RETURN SINCE INCEPTION (%) COMMENT Overweight UK Gilts Within European Fixed-Income Portfolios 05/16/2022   Cyclical Buy European Healthcare Equities / Sell UK Healthcare Equities 05/16/2022   Tactical Buy European Financials Equities / Sell UK Financials Equities 05/16/2022   Tactical Bottom Line: British Gilts will outperform because of the weakness in UK economic activity, but the trade-weighted pound will remain under pressure. The performance of UK large-cap names is mostly independent from the state of the British economy. The commodity secular bull market will create a potent tailwind for this market. However, a better entry point lies ahead.       The Bank of England’s (BoE) latest policy meeting was a cold shower for market participants and their aggressive interest rate pricing in the SONIA curve. Money markets expected a peak in the Bank Rate of 2.7% in 2023, but the BoE’s new Market Participants Survey is calling for it to peak at 1.75% before easing off to 1.5% in 2024. The UK economy is in trouble. Inflation is high and broad-based, which explains why investors are pricing in such an aggressive path for the Bank Rate. Yet, economic activity is weakening and could even contract in early 2023. The BoE clearly puts more weight on growth than investors do. What are the implications of the inflation, growth, and policy outlook for British assets? BCA has upgraded its view on UK bonds to overweight within global fixed income portfolios. We expect more softness in the pound versus the euro. UK large-cap stocks will continue to trade in line with energy dynamics, which means it is still too early to buy British small-cap equities. In the meantime, UK financial and healthcare names will underperform their Euro Area counterparts. Growth To Weaken Further The -0.1% month-over-month GDP contraction in March underscores that UK economic activity has already decelerated sharply. However, the deterioration is only starting. Most sectors of the economy show ominous signs for the quarters ahead. Consumer Sector The biggest hurdle facing UK consumers, like most of their European neighbors, is the surge in inflation, particularly energy and food prices. Safety nets are looser than on the continent, and UK households’ real disposable income are contracting sharply. The impact of this weakening of activity is already visible. UK consumer confidence is falling in line with the knock to real disposable income (Chart 1, top panel). Moreover, real retail sales have already slowed sharply, and the BRC Like-For-Like Retail Sales measure is contracting on an annual basis (Chart 1, bottom panel). As a result, the outlook for consumption is worsening. Ofgem, the UK gas and electricity market regulator, lifted its energy price cap by 54% on April 1st and plans to increase it again by an expected 40% in October. Consequently, the BoE anticipates the share of households’ disposable income spent on energy to hit 7.7% by the end of the year — its highest level since the early 1980s (Chart 2). Chart 1Falling Real Incomes Hurt Falling Real Incomes Hurt Falling Real Incomes Hurt Chart 2Intensifying Energy Drag Intensifying Energy Drag Intensifying Energy Drag The savings cushion developed during the pandemic will not be enough to prevent weaker retail sales. More than 40% of households plan to dip into their existing savings and curtail their savings rate; however, UK excess savings skew heavily toward the richer households. Poorer households with low savings are the ones who spend the largest share of their income on energy (Chart 3), and they are also the ones with a higher marginal propensity to consume. Thus, the knock to these households portends further weakness in consumption volumes. Chart 3The Poor Are Hit Harder Is UK Stagflation Priced In? Is UK Stagflation Priced In? Chart 4No Salvation From Housing No Salvation From Housing No Salvation From Housing Housing is unlikely to save the day. While house prices and housing transactions are robust (Chart 4, top panel), mortgage approvals are declining rapidly and average sales per chartered surveyors are also softening (Chart 4, bottom panels), which suggests housing activity will slow. Rising mortgage rates are a problem. Since January, the quoted rates on mortgages with 90% LTV and 75% LTV are up 65bps and 70bps, respectively, which is hurting housing marginal demand. Moreover, 20% of the UK’s mortgage stock carries variable rates, which further hurts aggregate demand. Business Sector The business sector is also feeling the crunch from rapidly rising energy and input costs. It also dreads the deterioration in consumer sentiment and its implication for future final demand. Chart 5Dwindling Capex Outlook Dwindling Capex Outlook Dwindling Capex Outlook Business confidence is falling abruptly. The CBI Inquiry Business Optimism measure has fallen to its lowest level since the beginning of the pandemic in 2020, when the UK GDP was contracting at a 21% annualized rate (Chart 5). Unsurprisingly, the collapse in business confidence prompted a rapid slowdown in CAPEX. The BoE’s Agents Survey reports that 40% of UK firms have unsustainably low profit margins because of rising input prices and partial pass-through. As a result of financial stress, further capex weakness is likely in the coming quarters. The impact on overall activity of these expanding worries is evident. UK industrial production has slowed very sharply and is now a meager 0.7% on an annual basis. The situation will degrade. Export growth remains strong, which is helping the business sector; however, the rapid slowdown in global industrial production indicates that UK exports will follow suit (Chart 5, second panel). This will have a knock-on effect on corporate profits (Chart 5, bottom panel), which will depress capex further. Other Considerations Chart 6No Offset From The Government No Offset From The Government No Offset From The Government The problems of the private sector may be encapsulated in one indicator. After a surge that boosted GDP, the UK’s nonfinancial private sector’s credit impulse is rapidly contracting (Chart 6), which confirms that risks to activity are building. The public sector will not provide an offset. According to the IMF Fiscal Monitor’s projections, the UK’s fiscal thrust will equal -3.3% of GDP in 2022 and -1.4% in 2023, even after the small giveaways from Chancellor Rishi Sunak’s Spring Statement (Chart 6, bottom panel). Together, these developments confirm our view that UK GDP may also flirt with a recession in the coming 12 months. Bottom Line: The UK economy is facing potent headwinds and activity is set to contract over the coming quarters. Surging energy costs are hurting household consumption and businesses are cutting investment. This time around, government spending is unlikely to come to the rescue, at least not until further pain is inflicted on the UK’s private sector. The BoE expects output to contract in early 2023, with which we agree. Inflation: The Worst Of Both Worlds UK headline inflation is likely to move into double digits territory before year-end. Worrisomely, it will also be more stubborn than that of the Eurozone, because it goes beyond higher food and energy input costs. Essentially, the UK suffers from both the cost-push inflation plaguing the rest of Europe and the demand-pull inflation witnessed in the US. Chart 7Continued Pass-Through Is UK Stagflation Priced In? Is UK Stagflation Priced In? The UK’s cost-push inflation will worsen in the second half of the year and could lift headline CPI above 10% by Q4 2022. Its main driver will be the Ofgem’s second energy cap increase scheduled for October, which is expected to increase household energy costs by 40%. Companies will also try to pass through a greater proportion of their rising costs to their consumers to protect their depleted margins. So far, the BoE’s Agents Survey reveals that on average, UK firms have passed through 80% of their non-labor input cost increases (Chart 7, top panel). In all the sectors surveyed, expected price increases are set to accelerate compared to the past 12 month and may even reach 14% in the manufacturing sector and 8% in the consumer goods sector (Chart 7, bottom panel). Demand-pull inflation is also present in the UK, unlike the rest of Europe, with core CPI at 5.7%, high service inflation, and rapidly rising wage growth. The key problem is an overheating labor market exacerbated by labor supply problems. By the end of 2021, the UK recorded 600 thousand inactive people more than before the pandemic, or individuals who are of working age but outside of the labor force and not seeking a job. This has compressed the labor participation rate to 63%, or the lowest level since the 2011-2012 period (Chart 8). So far, not even rapid wage gains have incentivized these persons to seek employment. The impact of Brexit further curtails the supply of labor. Since the pandemic began, the size of the working age population has decreased by 100 thousand as EU citizens have moved back home (Chart 8, second panel). Labor demand, however, is not weak. Job vacancies have surged to an all-time high of 1.3 million, or a ratio of one job vacancy per unemployed worker. Moreover, according to the BoE’s Agents Survey, the proportion of firms reporting recruitment difficulties is extremely elevated (Chart 8, third panel). As a result of weak labor supply but strong labor demand, wages are rising rapidly (Chart 8, bottom panel), with the KPMG/REC Indicator of pay higher than 6%. Chart 8Labor Market Tightness Labor Market Tightness Labor Market Tightness Chart 9Poor Productivity Weighs On Trend GDP Poor Productivity Weighs On Trend GDP Poor Productivity Weighs On Trend GDP Rapidly increasing wages and underlying inflation are indicative of a greater malaise. UK GDP is still 3.6% below its pre-COVID trend, while US GDP has already moved past its previous peak. Yet, wages and underlying inflation are just as strong in both economies. This suggests that the UK trend GDP has slowed more than in the US and that aggregate demand is colliding more rapidly with the constraint created by a weaker potential GDP. Labor supply is not the only culprit behind the slowdown in UK’s trend GDP. Since Brexit, UK capex has been particularly weak, which has depressed productivity growth and suppressed trend GDP further (Chart 9). Bottom Line: The BoE expects UK headline CPI inflation to move above 10% before the end of the year. We agree with this assessment. Cost-push inflation will remain strong in response to additional increases in regulated energy prices this fall and greater pass-through from businesses. Meanwhile, the labor market is overheated because of weak labor supply and surging job vacancies. The UK core inflation is likely to be sticky as Brexit weighs on the country’s trend GDP, which causes aggregate demand to surpass aggregate supply easily. Investment Implications The investment implications of the UK’s weak growth and strong inflation outlook are far reaching. Fixed Income Implications BCA’s Global Fixed Income Strategy service upgraded UK government bonds to overweight from underweight in their global fixed income portfolios. We heed this message and move to overweight UK Gilts relative to German Bunds within European fixed income portfolios. Chart 10The BoE's Dovish Justification The BoE's Dovish Justification The BoE's Dovish Justification The BoE’s forecast calls for a deeply negative output gap as well as a rising rate of unemployment in 2023 and 2024. According to the BoE’s model, these dynamics will weigh on headline CPI next year (Chart 10). We take the BoE at its word when it communicated a gentler pace of rate hikes than was anticipated by the SONIA curve. The BoE believes that the weakness in the UK’s trend GDP growth weighs on the country’s neutral rate of interest. Thus, there is a limited scope before higher interest rates hurt economic activity. Since the BoE already foresees a poor growth outcome and weaker inflation next year, this view of the neutral rate logically results in a shallow path of interest rate increases. In other words, the BoE is not the Fed. This view prompts our fixed income colleagues to expect the SONIA curve to move toward the gentler rhythm of interest rate hikes proposed by the BoE. As a corollary, it implies that Gilt yields have more downside. More specifically, BCA sees room for UK-German yields spreads to narrow. Investors have expected the BoE to be significantly more hawkish than the European Central Bank (ECB), and a partial convergence in expected interest rate paths is likely. Moreover, UK yields have a higher beta than German ones. As a result, the current wave of risk aversion driven by global growth fears should cause an outperformance of UK government bonds compared to German ones. Currency Market Implications The outlook for GBP/USD depends on the evolution of overall market conditions. If risk assets remain under pressure, so will Cable. Chart 11Cable And EM Stocks Cable And EM Stocks Cable And EM Stocks A durable bottom in GBP/USD will coincide with a rebound in EM equities (Chart 11). The correlation between these two assets most likely reflects the UK’s current account deficit of 2.8% of GDP in 2021. Large external financing needs render the currency very sensitive to global liquidity conditions and thus, to the dollar’s trend and global risk aversion, as is the case with EM assets. Peter Berezin, BCA Chief Global Strategist, expects global stocks to rebound in the near future, which will lift EM equities in the process. Interestingly, GBP/USD does not correlate with the relative performance of EM shares. Thus, a rebound in Cable does not contradict BCA’s Emerging Market Strategy service’s view that EM stocks are likely to underperform further in the coming months. Chart 12A Big Handicap For the GBP vs the EUR A Big Handicap For the GBP vs the EUR A Big Handicap For the GBP vs the EUR BCA’s Foreign Exchange strategy team sees further upside in EUR/GBP, toward the 0.9 level. 2-year yield differentials between the UK and Germany are likely to narrow in response to the downgrade of the SONIA curve. Importantly, the wide UK current account deficit necessitates higher real interest rates to prop the pound against the euro because the Eurozone current account surplus stands at 2.3% of GDP. However, neither the 2-year nor 10-year real rates are higher in the UK than they are in the Euro Area (Chart 12). Additionally, even the nominal yield premium of UK bonds vanishes once they are hedged into euros. UK hedged 2-year bonds yield 50bps less than their German counterparts, and 10-year Gilts offer 80bps less than Bunds, which limits continental inflows into the UK. Equity Market Implications UK stocks are pro-cyclical, and their absolute performance will bottom in tandem with global equities. The near-term outlook for global equities remains clouded by the confluence of global growth fears, a weaker CNY, and tighter monetary policy around the world. Meanwhile, UK stocks are very cheap, trading at a forward P/E ratio of 11. They are tactically oversold and are lagging forward earnings (Chart 13). Relative to global equities, the performance of UK stocks will continue to track that of global energy firms compared to the broad market. The heavy exposure of UK large-cap indices to oil and gas stocks has been a major asset since energy shares have become market darlings (Chart 14). Chart 13UK Stocks Are Close To A Bottom UK Stocks Are Close To A Bottom UK Stocks Are Close To A Bottom Chart 14UK Large-Caps Are About Oil UK Large-Caps Are About Oil UK Large-Caps Are About Oil At the time of writing, Sweden and Finland have yet to officialize their membership application to NATO, but BCA’s Geopolitical Strategy team assigns a high probability to this outcome. Russia will not stand idly by, especially as the EU threatens to cut their oil imports. Consequently, a deeper energy embargo is increasingly likely, which should prompt a temporary but violent rally in oil and natural gas prices. This process should sustain a few more weeks of outperformance from UK large-cap shares relative to the rest of the world. Chart 15The UK vs The Eurozone: Cheap But Overbought The UK vs The Eurozone: Cheap But Overbought The UK vs The Eurozone: Cheap But Overbought Structurally, UK equities are likely to remain well supported. A pullback in relative performance later this year is possible once oil prices ease off as BCA’s Commodity and Energy team expects. However, the oil market will stay tight for years to come because of the investment dearth observed since 2014-2015, when OPEC 2.0 started its market-share war. According to Bob Ryan, BCA’s Chief Commodity Strategist, it will take years of high returns in the sector to attract the capital needed to lift energy capex enough to line up supply with demand. Thus, energy remains a structurally favored sector, which will boost the cheap UK market’s appeal. UK stocks enjoy a structural tailwind relative to Euro Area shares. They remain cheap, because they still trade at a significant historical discount (Chart 15). Moreover, relative earnings are moving decisively in favor of UK stocks, something that is unlikely to change, even if the UK economy contracts. Ultimately, UK large-cap names derive the bulk of their profits from overseas and the structural tailwind of a secular commodity bull market will continue to assert itself on relative profits. Nevertheless, UK shares have also become extremely overbought, which raises the risk of a pullback in the second half of the 2022 (Chart 15, third and fourth panel). The recent outperformance of UK stocks relative to those of the Eurozone has been larger than what sectoral biases explain. An equal-sector weights version of the UK MSCI has outperformed a similarly constructed Euro Area index by 9.6% year-to-date. Chart 16Waiting For Catalysts To A Eurozone Rebound Waiting For Catalysts To A Eurozone Rebound Waiting For Catalysts To A Eurozone Rebound A tactical rectification of the overbought conditions in the performance of UK equities relative to those of the Euro Area will require an ebbing of stagflation fears in the Euro Area (Chart 16, top panel). This implies that investors looking to buy Eurozone equities are waiting for a stabilization in the energy market (that is, waiting for clarity about Sweden’s and Finland’s NATO decision as well as Russia’s response). It also means that the Chinese economy must stabilize, since Eurozone equities are more sensitive to the evolution of the Chinese credit impulse than UK ones (Chart 16, second panel). Nonetheless, BCA’s Global Fixed Income Strategy team’s view on UK-German spreads is consistent with an eventual tactical pull back in the relative performance of UK stocks vis-à-vis Euro Area ones (Chart 16, bottom panel). Two pair trades make attractive vehicles to bet on an underperformance of UK stocks relative to those of the Euro Area in the second half of 2022. The first one is to sell UK financials at the expense of Euro Area financials. Historically, a decline in UK Gilt yields relative to their German equivalent strongly correlates with an underperformance of UK financials (Chart 17). The second one is to sell UK healthcare names relative to those in the Eurozone. The relative performance of healthcare shares has greatly outpaced relative earnings and is now hitting a critical resistance level (Chart 18). Moreover, UK healthcare firms are exceptionally overbought relative to their Euro Area competitors. Importantly, those two trades display little correlation to the broad market trend. Chart 17Challenges To UK Financials Challenges To UK Financials Challenges To UK Financials Chart 18UK Healthcare: Running Ahead Of Itself UK Healthcare: Running Ahead Of Itself UK Healthcare: Running Ahead Of Itself Finally, UK small-cap stocks are becoming attractive relative to their large-cap counterparts, although the timing remains risky. Unlike the internationally focused large-cap indices, small-cap shares are a direct bet on the health of the UK domestic economy. Hence, small- and mid-cap names have massively underperformed the FTSE-100 as market participants sniffed out the poor outlook for UK economic activity (Chart 19). They are now extremely oversold relative to large-cap names and their overvaluation has been corrected. The main problem with small-cap shares is the lack of a catalyst to rectify their oversold conditions. The most likely candidate for such a reversal would be a peak in energy inflation, considering it stands at the crux of the headwinds that UK consumption and growth face. However, energy CPI will not peak until later this fall and thus, the pain on UK households will build until then. As a result, wait for a clear sign that energy inflation recedes before entering a long UK small-cap / short UK large-cap contrarian trade (Chart 20). Chart 19Bombed Out Small-Caps... Bombed Out Small-Caps... Bombed Out Small-Caps... Chart 20…Need A Peak In Energy Inflation ...Need A Peak In Energy Inflation ...Need A Peak In Energy Inflation Bottom Line: In line with our expectations that UK growth will worsen significantly in the quarters ahead, we follow the BCA Global Fixed Income team and move to overweight UK government bonds within European fixed income portfolios. While we expect GBP/USD will bottom once global risk assets find a floor, BCA’s Foreign Exchange Strategy team also anticipates Sterling to depreciate further relative to the euro. Because of their large energy and materials exposure, UK large-cap equities will enjoy a structural outperformance relative to Euro Area large-cap indices on the back of a secular bull market in commodities. However, a temporary pullback in the UK’s relative performance is likely in the second half of 2022. Selling UK financials and UK healthcare stocks relative to their Eurozone counterparts offers a compelling approach to implement this view. Finally, UK small-caps are oversold relative to large-caps, but we recommend investors wait until energy CPI peaks when a relative rebound may emerge.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations

Listen to a short summary of this report.     Executive Summary The Dollar Likes Volatility The Dollar Likes Volatility The Dollar Likes Volatility Uncertainty about Fed policy has supercharged volatility in bond markets, and correspondingly, USD demand (Feature chart). A well-telegraphed path of interest rates will deflate the volatility “bubble” in Treasury markets and erode the USD safety premium. The dollar has also already priced in a very aggressive path for US interest rates. The onus is on the Fed to deliver on these expectations. Our theme of playing central bank convergence – by fading excessive hawkishness or dovishness by any one central bank – continues to play out. Our latest candidate: short EUR/JPY. The Russia-Ukraine conflict, and ensuing volatility in oil markets, is providing some trading opportunities. One of those is that “good” oil will continue to trade at a premium to “bad” oil. Go long a basket of CAD and NOK versus the RUB. TRADES* INITIATION DATE INCEPTION LEVEL TARGET RATE STOP LOSS PERCENT RETURNS SPOT CARRY** TOTAL Short DXY 2022-05-12 104.8 95 107       Short EUR/JPY 2022-05-12 133.278 120 137       Bottom Line: We recommended shorting the DXY index on April 8th at 102, with a tight stop at 104. That stop-loss was triggered this week. We are reinitiating this trade this week at 104.8, in line with our cyclical view that the dollar faces downside on a 12–18 month horizon.       Multiple factors tend to drive the dollar: Real interest rate differentials, growth divergences, portfolio flows into both public and private capital markets, or even safe-haven demand. Across both developed and emerging market currency pairs, the dollar has been strong (Chart 1), but what has been the key driver of these inflows? For most of this year, interest rate differentials have played a key role in pushing the dollar higher. That said, they have not been the complete story. Chart 2 shows that the dollar has very much overshot market expectations of Fed interest rate policy, relative to other central banks. That premium has been around 8%-10% in the DXY index. In real terms, the overshoot has been even higher. Chart 1The Dollar Has Been King Month In-Review: A Hefty Safe-Haven Premium In The Dollar Month In-Review: A Hefty Safe-Haven Premium In The Dollar Chart 2The Fed And The Dollar The Fed And The Dollar The Fed And The Dollar Chart 3The Dollar Likes Volatility The Dollar Likes Volatility The Dollar Likes Volatility A key source of this safe-haven premium has been rising volatility, specifically in the bond market. For most of the last two years, the dollar has tracked the MOVE index, a volatility measure of US Treasurys (Chart 3). Uncertainty about the path of US interest rates, and the corresponding rise in dollar hedging costs, have ushered in a wave of “naked” foreign buyers – owning USTs without a corresponding dollar hedge. Foreign purchases of US Treasurys are surging. Speculators have also expressed bearish bets on the euro, yen, and even sterling via the dollar. There is a case to be made that some of these bullish dollar bets will be unwound in the next few months, even if marginally. For example, the market expects rates to be 248 bps and 313 bps higher in the US by year end, respectively, compared to the euro area and Japan (Chart 4). This might be exaggerated. The real GDP growth and inflation differential between the eurozone and the US is 0.1% and 0.8%, respectively, for 2022. The difference in the neutral rate could be as low as 1.25%. This suggests that a simplified Taylor-rule framework will prescribe a policy rate differential of only 1.7% (1.25 + 0.5(0.8+0.1)). In a global growth slowdown, US inflation will come in much lower, which will allow the Fed to ratchet back interest rate expectations. Should growth accelerate, however, then growth differentials between open economies and the US will widen, narrowing the policy divergence we have been experiencing. The safe-haven premium in the dollar has also been visible in the equity market. One striking feature of the correction has been the inability for US equities to outperform, as they usually do, during a market riot point. The carnage in technology stocks has been absolute, and the tech-heavy US equity market continues to struggle against its global peers. As such, there has been a break in the historically strong relationship between the dollar and the outperformance of the US equity market (Chart 5). Chart 4Pricing In The Euro And Yen In Line With Rates Pricing In The Euro And Yen In Line With Rates Pricing In The Euro And Yen In Line With Rates Chart 5The Dollar Has Overshot The Relative Performance Of US Equities The Dollar Has Overshot The Relative Performance Of US Equities The Dollar Has Overshot The Relative Performance Of US Equities As US equity markets were surging throughout 2021, investors started accumulating dollars as a hedge against equity market capitulation, which explained the tight correlation between the put/call ratio and the USD (Chart 6). As the carry on the dollar has risen, and puts have become more expensive, our suspicion is that the greenback has become a preferred hedge. Chart 6Dollar Hedges Against A Drawdown In The S&P Dollar Hedges Against A Drawdown In The S&P Dollar Hedges Against A Drawdown In The S&P As we have highlighted in past reports, the dollar continues to face a tug of war. Higher interest rates undermine the US equity market leadership, while lower rates will reverse the record high speculative positioning in the dollar. Given recent market action, the path of US bond yields will be critical for the dollar outlook. Cresting inflation could pressure bond yields lower. As a strategy, we recommended shorting the DXY index on April 8th at 102, with a tight stop 104. That stop-loss was triggered this week. We are reinitiating this trade at 104.8, in line with our cyclical view that the dollar faces downside on a 12–18-month horizon. As usual, this week’s Month In Review report goes over our take on the latest G10 data releases and the implications for currency strategy both in the near term and longer term.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com   US Dollar: Inflation Will Be Key Chart 7How Sustainable Is The Breakout? How Sustainable Is The Breakout How Sustainable Is The Breakout The dollar DXY index is up 9% year-to-date, hitting multi-year highs (panel 1). The Fed increased interest rates by 50bps this month. In our view, the Fed will continue to calibrate monetary policy based on data, and the key releases continue to surprise to the upside. Headline CPI came in at 8.3% in April, while the core measure was at 6.2%. Both were higher than expected. Importantly, the month-on-month rate for core was 0.6%, much higher than a run rate of 0.2% that will be consistent with the Fed’s target of inflation (panel 2). It is important to note that used car prices have had an important contribution to US CPI. Airfares had an abnormally large contribution to US CPI for the month of April. As these prices crest, along with other supply-driven costs, inflation could meaningfully roll over in the coming months (panel 3). The job’s report was robust, but there was disappointment in the participation rate that fell from 62.4% to 62.2%. This suggests there might be more labor slack in the US than a 3.6% unemployment rate suggests. Wages continue to inflect higher. The Atlanta Fed Wage Growth Tracker currently sits at 6% (panel 4). These developments continue to underpin market expectations for aggressive interest rate increases. The market now expects the Fed to raise rates to 2.5% by December 2022. Speculators are also very long the dollar. Three factors could unhinge market expectations. First, inflation could come crashing back down to earth which will unwind some of the rate hikes priced in the very near term. That would hurt the dollar. Second, growth could pick up outside the US, especially in economies with lots of pent-up demand like Japan. Third, financial conditions could ease, which will help revive animal spirits. In conclusion, our 3-month view on the dollar remains neutral, but our 12-18-month assessment is to sell the dollar. We are reinitiating our short DXY position today with a stop-loss at 106.  Euro: A Recession Is Priced Chart 8Go Short EUR/JPY Go Short EUR/JPY Go Short EUR/JPY The euro has broken below 1.05 and the whisper circulating in markets is that parity is within striking distance. EUR/USD is down 8.7% year-to-date. We have avoided trading the euro against the dollar and have mostly focused on the crosses – long EUR/GBP, and this week, we are selling EUR/JPY. The euro is in a perfect tug of war: Rising inflation is threatening the credibility of the ECB while there is the risk of slowing growth tipping the euro area into a recession. In our view, the euro has already priced in the latter, much more than potentially higher rates in the eurozone. The ZEW sentiment index, a gauge of European growth prospects, is at COVID-19 lows, along with EUR/USD (panel 1). My colleague, Mathieu Savary, constructed a stagflation index for Europe which perfectly encapsulates the ECB’s quandary. A growing cohort of ECB members are supporting a July rate hike. On the surface, the ECB has the lowest rate in the G10 (outside of Switzerland). With HICP inflation at 7.5% (panel 2), emergency monetary settings are no longer required. A “least regrets” approach suggests gently nudging rates higher to address inflationary pressures. House prices in Germany and Italy are rising at their fastest pace in over a decade, much more than wage inflation (panel 3). The key for the ECB will be to telegraph that policy remains extremely accommodative. It is hard to envision that hiking rates from -0.5% to -0.25% will trigger a European recession, but the ECB will need to balance that outcome with the possibility that inflation crests and real rates rise in Europe. In our trading books, we are long EUR/GBP as a play on policy convergence between the ECB and the BoE. This week, we are playing the same theme via shorting EUR/JPY. In a risk-off environment, EUR/JPY should fall. In an economic boom, the cross has already priced in a stronger euro, relative to the yen (panel 4). We are neutral on the euro over a 3-month horizon but are buyers over 12-18 months.  Japanese Yen: A Mean-Reversion Play Chart 9A Capitulation In The Yen? A Capitulation In The Yen? A Capitulation In The Yen? The Japanese yen is down 10.5% year-to-date, one of the worst performing G10 currency this year. In retrospect, a chart formation since 1990 suggests that we witnessed a classic liquidation phase that could only be arrested by an exhaustion in selling pressure, or a shift in fundamentals (panel 1). The two key drivers of yen weakness are the rise in US yields (panel 2) and the higher cost of energy imports. As today’s price move suggests, any reversal in these key variables will lead to a selloff in USD/JPY – falling bond yields and/or lower energy prices. We have been timidly long the yen, via a short CHF position. Today we are introducing a short EUR/JPY trade as well. What has been remarkable in the last month is the improvement in Japanese economic fundamentals, as the country slowly emergences from the latest COVID-19 wave: Both the outlook and current situation components of the Eco Watchers Survey improved in April. This is a survey of small and medium-sized businesses, very sensitive to domestic conditions. PMIs in Japan are improving on both the manufacturing and service fronts. The Tokyo CPI surprised to the upside, with the headline figure at 2.5%. Historically, the earlier release of the Tokyo CPI has been a reliable gauge for nationwide inflation. Importantly, the release was much below BoJ forecasts. Inflation in Japan could surprise to the upside (panel 3). Employment numbers remain robust. The unemployment rate fell to 2.6% in March, and the jobs-to-applicants ratio rose to 1.22. The Bank of Japan has stayed dovish, reinforcing yield curve control in its April 27 meeting, with strong forward guidance. That said, the BoJ will have no choice but to pivot if inflationary pressures prove stronger than they anticipate, and/or the output gap in Japan closes much faster as demand recovers. Related Report  Foreign Exchange StrategyWhat To Do About The Yen? We were stopped out of our short USD/JPY position at 128. In retrospect, USD/JPY rallied above 131 and is finally falling back down to earth. We are already in the money on our short CHF/JPY position, from our last in-depth report on the yen. This week, we recommend shorting EUR/JPY.  British Pound: A Volte-Face By The BoE Chart 10The Pound Is Being Traded As High Beta The Pound Is Being Traded As High Beta The Pound Is Being Traded As High Beta The pound is down 9.8% year-to-date. While the Bank of England raised rates to 1% this month, they also expect the economy to temporarily dip into recession this year. This week’s disappointing GDP release confirmed the BoE’s fears. In short, pricing in the SONIA curve for BoE rate hikes remains aggressive. The Bank of England has been one of the more proactive central banks, yet the currency has been performing akin to an inflation crisis in emerging markets (panel 1). Inflation continues to soar in the UK with headline CPI now at 6.2% (panel 2). According to the BoE’s projections, inflation will rise to around 10% this year before peaking, well above previous forecasts of 8%. Together with tighter fiscal policy, the combination will be a hit to consumer sentiment. While the BOE must contain inflationary pressures (in accordance with their mandate), the risks of a policy mistake have risen, akin to the eurozone. Labor market conditions appear tight on the surface (panel 3), but our prognosis is that the UK needs less labor regulation, especially towards areas in the economy where labor shortages are acute and are pressuring wages higher. That is unlikely to change in the near term. As such, the current stance of tight monetary and fiscal policy will stomp out any budding economic green shoots. We are currently short sterling, via a long EUR position. In our view, the EUR/GBP cross still heavily underprices the risks to the UK economy in the near term. Given that the pound is very sensitive to global financial conditions (panel 1), it could rebound if recession fears ease, but our suspicion is that it will still underperform the euro.  Canadian Dollar: The BoC Will Stay Hawkish Chart 11The CAD Will Stay Resilient The CAD Will Stay Resilient The CAD Will Stay Resilient The CAD is down 3% year-to-date. The key driver of the CAD remains the outlook for monetary policy and the path of energy prices (panel 1). In the near term, oil prices will stay volatile, but the CAD has not priced in the fact that the BoC is matching the Fed during this interest rate cycle, and/or the rise in energy prices. Together with the NOK, we are going long the CAD versus the RUB today. As we expected, the Bank of Canada raised interest rates by 50bps to 1% at the April 13 meeting. Since then, all the measures the BoC looks at to calibrate monetary policy are continuing to suggest more tightening in monetary policy. Both headline and core inflation came in strong, with headline inflation at 6.7% in March. The common, trim, and median inflation prints were at 2.8%, 4.7%, and 3.8%, respectively, well above the BoC’s target. This continues to suggest inflationary pressures in Canada are broad- based (panel 2). The employment report in April disappointed market consensus, but employment in Canada is back above pre-pandemic levels, and the unemployment rate fell to 5.2%, close to estimates of NAIRU. This suggests the BoC’s path for monetary policy will not be altered (panel 3). House price inflation seems to be moderating across many cities, which argues that monetary policy is having the intended effect, but price increases remain well above nominal income growth (panel 4). Speculators are slightly long the CAD, a risky stance over the next three months. That said, we are buyers of CAD over a 12-to-18-month horizon.  New Zealand Dollar: Positive Catalysts, But Fairly Valued Chart 12Real NZ Rates Need To Stabilize Real NZ Rates Need To Stabilize Real NZ Rates Need To Stabilize The NZD is down 8.7% year-to-date. The RBNZ remains the most hawkish central bank in the G10. They further raised interest rates to 1.5% on April 13. Given a strict mandate on inflation, together with house price considerations, long bond yields have accepted that the RBNZ will be steadfast in tightening policy and hit 3.8% this month. This will help stabilize real yields are rising (panel 1). Underlying data suggests that the “least regrets” approach by the RBNZ makes sense – in a nutshell, tighten policy as fast as economically possible, to get ahead of the inflation curve. CPI continues to accelerate, hitting 6.9% year-on-year in Q1, from 5.9% the previous quarter (panel 2). House price inflation is rolling over from very elevated levels (panel 3). This suggests that monetary policy is having the intended effect of dampening demand.  A weak NZD could sustain imported inflation, but a hawkish central bank cushions this risk.   The RBNZ is forecasting a 2.8% overnight rate for June 2023. The OIS curve suggests that market expectations are much higher. This fits with our view that the market had been overpricing higher interest rates in New Zealand, especially relative to other countries. We already took profits on our long AUD/NZD trade and continue to expect the NZD to underperform at the crosses, even if it rises versus the dollar.  Australian Dollar: Our Top Pick Against The Dollar Chart 13The AUD Has A Terms Of Trade Tailwind The AUD Has A Terms Of Trade Tailwind The AUD Has A Terms Of Trade Tailwind The Australian dollar is down 5.5% year-to-date. The Reserve Bank of Australia raised interest rates by 15bps on its May 3rd meeting, in line with the hawkish tone telegraphed at the prior meeting. The two critical measures that the RBA is focusing on, inflation and wages, have been improving. That said, we had expected the RBA to wait for fresh wage data, out next week, before calibrating monetary policy. The key point is that emergency monetary settings are no longer required in Australia. Home prices remain robust, the unemployment rate has fallen to a cycle low of 4% in and inflationary pressures remain persistent.  Headline CPI was at 5.1% year-on-year in Q1. The trimmed-mean and weighted- median CPI print came in at 3.7% and 3.2%, respectively, above the upper bound of the RBA’s 2%-3% target range. The external environment is one area of concern for the AUD. The trade balance continues to soar, but China’s zero COVID-19 policy is a risk to Australian exports. On the flip side, many speculators are now short the Aussie, which is bullish from a contrarian perspective. We are long the AUD as of 72 cents, expecting this trade to be volatile in the near term, but to pay off over a longer horizon.  Swiss Franc: The Yen Is A Better Hedge Chart 14Swiss Inflation Will Fall Swiss Inflation Will Fall Swiss Inflation Will Fall Year-to-date, CHF is down 9% against USD and flat against the EUR.  The Swiss economy continues to perform well and remains relatively insulated from the inflation dynamics taking place in the rest of the G10. In April, headline CPI inched higher to 2.5% and core CPI to 1.5% year-over-year (panel 2), while the unemployment rate was down to 2.3%. The KOF indicator was also above expectations at 101.7. At 62.5, the manufacturing PMI is still well in the expansionary zone. In other data, retail sales were up 0.8% month-on-month in March and the trade surplus was down to CHF 1.8bn, likely due to the elevated exchange rate versus the euro. Since then, the franc has given up all its gains against the euro. Several SNB board members have recently spoken about the beneficial role of a strong franc in helping to control inflation (panel 4). That said, it is unclear whether the SNB, known for rampant currency interventions, will be as welcoming to a highly valued franc should inflation roll over. Switzerland’s trade surplus as a share of GDP has been persistently increasing since the early 2000s. An expensive currency would not be positive for economic growth. In fact, SNB sight deposits, have been on the rise recently. Last week, these deposits posted the largest one-week increase in two years. In a world where inflation starts to roll over, the SNB will be more dovish. In this environment, EUR/CHF can see more upside.  Norwegian Krone: Bullish On A 12-to-18 Month Horizon Chart 15NOK Has Upside Month In-Review: A Hefty Safe-Haven Premium In The Dollar Month In-Review: A Hefty Safe-Haven Premium In The Dollar The NOK is down 10.7% against the USD this year. This is a remarkable development amidst higher real rates in Norway (panel 1). The Norges Bank is one of the most predictable central banks. It is set to deliver quarterly 25bps hikes through the end of 2023 to a total of 2.5%. In April, headline CPI rose 5.4% and the measure excluding energy was up 2.6% (panel 2). Although slightly above the latest projections, these figures are unlikely to make the bank deviate from its projected rate path. Economic activity is recovering steadily since the removal of pandemic-related restrictions in February. Household consumption and retail sales grew 4.3% and 3.3% month-over-month, respectively, in March. The manufacturing PMI broke above the 60 level in April, while industrial production was up 2.2% on the month in March. Registered unemployment fell under 2% in April, below pre-pandemic levels. This is helping boost wages (panel 3). Norway’s trade balance continued to break all-time highs with a NOK 138bn surplus in March. Elevated energy prices and the transition away from Russian energy should be a significant tailwind for the Norwegian economy. Oil companies planned to increase investment even before the invasion, and recent developments will likely induce more capex. NOK has significantly underperformed in the last month largely due to broad risk-off sentiment. Once markets stabilize, the krone should strengthen over the next 12–18 months. Given the relatively “safer” nature of Norwegian oil, we are initiating a long NOK/RUB trade today, along with a long CAD leg.  Swedish Krona: Into A Capitulation Phase Chart 16SEK Has Upside SEK Has Upside SEK Has Upside The SEK is down 10.8% versus the dollar this year. In a major policy U-turn, the Riksbank raised rates by 25bps during its last meeting, after inflation came in above expectations at 6.1% on the year in March. The Bank also announced a faster pace of balance-sheet reduction, as well as expecting two-to-three more hikes before the end of the year. Just like the euro area, Sweden is within firing range of tensions between Russia and Ukraine (panel 1). Swedish GDP contracted 0.4% from the previous quarter. Global uncertainty and rising prices are weighing on consumer confidence, reflected in subdued retail sales and household consumption in March. The manufacturing PMI remains robust at 55 but is falling quite rapidly, as are real rates (panel 2). As a small open economy, Sweden needs external demand to recover. On a positive note, orders remain very strong and an easing of lockdowns in China should contribute to growth in manufacturing and goods exports later this year. It is also encouraging that Sweden’s trade surplus rose to 4.7bn SEK in March.  The krona remains vulnerable to both a growth contraction in Europe as well as geopolitical risk, especially as Finland might join NATO, sparring retaliation from Russia. That said, the negative news is likely already priced in. SEK should benefit from growth normalization and a pick-up in the Chinese credit impulse in the second half of the year. As a way to benefit from this dynamic, we are short CHF/SEK, but short USD/SEK positions will be warranted later this year.  Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Artem Sakhbiev Research Associate artem.sakhbiev@bcaresearch.com   Footnotes Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary

Executive Summary The Fed, Bank of England (BoE) and Reserve Bank of Australia all hiked rates last week. The BoE, however, signaled a note of caution on future UK growth, given soaring energy prices and plunging consumer and business confidence.  Interest rate markets are pricing in a peak in UK policy rates over the next year near 2.5%, above realistic estimates of neutral that are more in the 1.5-2% range. UK productivity and potential growth remain too weak to support a higher neutral rate than that. With the BoE forecasting near recessionary conditions over the next couple of years if those market-implied rate hikes come to fruition, the time is right to increase exposure to UK government bonds in global fixed income portfolios. UK Rate Expectations Are Too High UK Rate Expectations Are Too High UK Rate Expectations Are Too High Bottom Line: Markets are overestimating how much additional tightening the Bank of England can deliver. We are upgrading our recommended strategic stance on UK Gilts from underweight (2 out of 5) to overweight (4 out of 5). Not All Central Bankers Can Credibly Restore Credibility Chart 1Developed Market Bond Yields Back To 2018 Highs Developed Market Bond Yields Back To 2018 Highs Developed Market Bond Yields Back To 2018 Highs Three more central bank meetings, three more rate hikes. Last week brought a 50bp hike from the Fed, a 25bp hike – the first of this tightening cycle – by the Reserve Bank of Australia (RBA) and a 25bp rate increase from the Bank of England (BoE). The Fed and RBA moves did little to stabilize the government bond bear markets in the US and Australia, but the BoE was able to provide a temporary reprieve for the Gilt selloff by playing up potential UK recession (stagflation?) risks. Bond yields worldwide remains laser focused on high global inflation and the associated monetary policy response that will be needed to stabilize inflation expectations (Chart 1). That includes both interest rate hikes and reducing the size of bloated central bank balance sheets. The threat of such “double tightening” is weighing on global growth expectations and risk asset valuations. The MSCI World equity index is down -6.4% (in USD terms) so far in the Q2/2022 and down -14.5% since the mid-November/2021 peak. Although in a more mitigated way, credit markets are also being impacted, with the Bloomberg Global High-Yield index down -2.6% so far in Q2 on an excess return basis versus government bonds. Rate hike expectations have started to catch up to elevated inflation expectations, at least according to inflation linked bonds. The yield on 10-year US TIPS now sits at +0.29%, a huge swing from the -1% level seen just one month ago (Chart 2). The 10-year real yield is even higher in Canada (+0.81%) where the Bank of Canada just delivered its own 50bp rate hike in April. On the other hand, 10-year real yields remain deeply below 0% in Europe and the UK, where central bankers have been providing less explicit guidance on future rate hikes and asset purchase reductions compared to the Fed or Bank of Canada. Interest rate markets remain reluctant to price in significantly positive real policy interest rates at the peak of the current tightening cycle. Our proxy for the real terminal rate expectation, the 5-year/5-year overnight index swap rate (OIS) minus the 5-year/5-year CPI swap rate, is only +0.18% in the US. It is still deeply negative in Europe (-1.53%) and the UK (-0.97%). Our estimates of the term premium component of 10-year government bond yields in those three markets is rising alongside interest rate expectations yet remains deeply negative in Europe and the UK (Chart 3). Chart 2Real Rate Divergences In The Face Of A Global Inflation Shock Real Rate Divergences In The Face Of A Global Inflation Shock Real Rate Divergences In The Face Of A Global Inflation Shock ​​​​​​ Chart 3Markets Still Pricing In Structurally Low Rates Markets Still Pricing In Structurally Low Rates Markets Still Pricing In Structurally Low Rates ​​​​​​ Of those three major bond markets, we see the UK term premium as being the least likely to see additional upward repricing, with the BoE less likely than the Fed or ECB to push for an aggressively smaller balance sheet given domestic economic risks. UK Rate Expectations Are Too Hawkish Chart 4Our BoE Monitor Justifies Recent Tightening Moves Our BoE Monitor Justifies Recent Tightening Moves Our BoE Monitor Justifies Recent Tightening Moves The Bank of England raised rates by 25bps last week, pushing Bank Rate to a 13-year high of 1.0%. The decision was a 6-3 majority, with three Monetary Policy Committee (MPC) members calling for a 50bp hike – matching recent moves by other G-10 central banks like the Fed and Bank of Canada – given tight UK capacity constraints (i.e. low unemployment) and high realized inflation. The MPC noted that additional rate increases would likely be necessary to tame very high UK inflation, a message confirmed by the elevated level of our UK Central Bank Monitor (Chart 4). However, the new economic forecasts presented by the BoE painted a gloomy picture on UK growth, raising the risks of a recession even as UK inflation is expected to continue climbing to a 10% peak in late 2022 on the back of high energy prices.1 Strictly looking at current inflation, the case for the BoE to continue hiking rates is obvious. Yet the BoE may now be placing more weight on the downside risks to growth from the energy shock, at a time when fiscal tightening is no longer providing stimulus. In the press conference following last week’s MPC meeting, BoE Governor Andrew Bailey noted the difficult situation policymakers are facing given the huge surge in energy prices that is fueling inflation while also weighing on household and business real incomes. So what is “neutral” anyway? Related Report  Global Fixed Income StrategyThe UK Leads The Way The BoE is one of the least transparent major central banks when it comes to providing guidance on what it thinks the neutral policy rate is. Market participants are left to arrive at their own conclusions and those can vary substantially, as is currently the case. The UK OIS curve is discounting a peak in rates of 2.72% in 2023 and discounting rate cuts after that starting in 2024. Yet the respondents to the BoE’s new Market Participants Survey are calling for a much lower trajectory with rates peaking at 1.75% before falling to 1.5% in 2024 (Chart 5). Those rate levels are in the lower half of the range of longer-run neutral rate estimates from the same Market Participants Survey, between 1.5% and 2.0% (the shaded box in the chart). Chart 5UK Rate Expectations Are Too High UK Rate Expectations Are Too High UK Rate Expectations Are Too High Chart 6Recessionary BoE Forecasts, Except For GDP Recessionary BoE Forecasts, Except For GDP Recessionary BoE Forecasts, Except For GDP Combining the messages from the OIS curve and the Survey, markets are pricing in a path for the BoE Bank Rate that will become restrictive by mid-2023, with another 172bps of rate hikes. The BoE uses market pricing for future interest rates in its economic forecasts. The Bank’s models suggest that a move to raise rates to 2.5% in response to high UK inflation, as markets are discounting, would result in a severe UK downturn that would both push up unemployment from the current 3.7% to 5.4% by Q2/2025 (Chart 6). Headline inflation would plunge to 1.3% over the same period as the UK output gap widens to -2.25% of GDP from the current “excess demand” level of +0.5%. Oddly enough, the BoE is only forecasting a flat profile for real GDP growth over that entire three-year forecasting period, although there will clearly be some negative GDP prints during that period to generate such a massively disinflationary outcome. A mixed picture on UK growth Currently, the UK economy is flashing some warning signs on growth momentum. The UK manufacturing PMI was 55.8 in April, still well above the 50 level indicating growth but 9.8 pts below the cyclical peak in 2021 (Chart 7). The services PMI is in better shape at 58.9, but it did dip lower in the latest reading. The GfK consumer confidence index has fallen sharply in response to contacting real household income growth, reaching the second-lowest reading in the history of the series dating back to 1974 in April. This is a warning sign for consumer spending – retail sales fell in April for the first time in fifteen months (middle panel). Business confidence is also impacted by the high costs of both energy and labor that is squeezing profit margins. UK real investment spending is nearly contracting on a year-over-year basis, despite the robust readings on investment intentions from the BoEs’ Agents Survey of UK businesses (bottom panel).UK firms are facing higher wage costs at a time of very tight labor market and robust labor demand. The BoE estimates that UK private sector wage growth, after adjusting for compositional effects related to the pandemic, will accelerate to 5.1% by the end of Q2/2022 (Chart 8). Chart 7UK Growth Facing Inflationary Headwinds UK Growth Facing Inflationary Headwinds UK Growth Facing Inflationary Headwinds ​​​​​​ Chart 8UK Labor Market Remains Healthy UK Labor Market Remains Healthy UK Labor Market Remains Healthy ​​​​​​ Chart 9Will House Prices Signal The Peak In UK Inflation? Will House Prices Signal The Peak In UK Inflation? Will House Prices Signal The Peak In UK Inflation? A robust labor market and quickening wage growth is forcing the BoE to maintain a relatively hawkish bias at a time of high energy inflation, even with the growth outlook darkening in the central bank’s own forecasts. Booming house prices are also making the central bank’s job more challenging. The annual growth rate of the Nationwide UK house price index reached 12.4%, a 17-year high, in March. However, rising mortgage rates and declining household real incomes will likely begin to eat into housing demand and, eventually, help slow the rapid pace of house price growth (Chart 9, bottom panel). Summing it all up, the overall UK inflation picture, including wages and housing costs in addition to energy prices and durable goods prices, will force the BoE to deliver a few more rate hikes before year-end before reaching a peak level that is lower than current market pricing. The neutral UK interest rate is likely very low Chart 10Structurally Weak UK Growth = A Low Neutral Rate Structurally Weak UK Growth = A Low Neutral Rate Structurally Weak UK Growth = A Low Neutral Rate The UK economy has suffered from structurally low potential economic growth dating back to the Brexit referendum in 2016. UK businesses stopped investing in the face of the uncertainty over the UK’s relationship with Europe. There has basically been no growth in UK fixed investment over the past five years. In response, UK productivity has only grown an annualized 0.9% over that same period (Chart 10) and the OECD’s estimate of UK potential GDP growth has been cut from 2% to 1.1%. With such low potential growth, the neutral BoE policy interest rate is likely even lower than the 1.5-2% range of estimates from the BoE’s Market Participant Survey. Tighter fiscal policy also lowers the neutral UK interest rate, with the UK Office of Budget Responsibility forecasting a narrowing of the UK budget deficit of -13.6 percentage points between the 2021 peak and 2027 (bottom panel). A flat UK Gilt curve is also a sign that the neutral interest rate is quite low. The 2-year/10-year Gilt curve now sits at a mere -49bps with Bank Rate only at 1% (Chart 11). While this is modestly steeper from the near-inversion of the curve seen at the start of 2022, a very flat curve at a nominal policy rate of only 1% suggests that the neutral rate is not far from the current level. Sluggish UK equity market performance and widening UK corporate credit spreads also argue that Bank Rate may already be turning restrictive, although a lower trade-weighted pound is helping to mitigate the overall tightening of UK financial conditions. Chart 11UK Financial Conditions Are Not Restrictive (Yet) UK Financial Conditions Are Not Restrictive (Yet) UK Financial Conditions Are Not Restrictive (Yet) ​​​​​​ Chart 12Pressure On The BoE Will Not Peak Until Inflation Does Pressure On The BoE Will Not Peak Until Inflation Does Pressure On The BoE Will Not Peak Until Inflation Does ​​​​​​ In the end, the pressure on the BoE to tighten will not ease until UK inflation peaks. The BoE is suffering a severe credibility crisis, with its own public opinion survey showing the deepest level of public dissatisfaction with the bank since the Global Financial Crisis (Chart 12). Inflation expectations are at similar levels that prevailed during that period, although the unique nature of the current inflation upturn, fueled by global supply-chain squeezes and war-related boosts to commodity prices, will likely prevent a repeat of the relatively fast reversal of inflation expectations seen after the Global Financial Crisis. Investment Implications – Get Ready For Gilt Outperformance Chart 13Upgrade UK Gilts To Overweight Upgrade UK Gilts To Overweight Upgrade UK Gilts To Overweight With the BoE already pushing Bank Rate towards a plausible neutral range, we do not expect many more rate hikes in the UK. Our base case is that the BoE hikes 2-3 more times by year-end, pushing Bank Rate to 1.5-1.75%, before pausing. This would represent a lower peak in policy rates than currently priced in the UK OIS curve. That is a relatively dovish outcome that typically leads to positive performance for a government bond market according to our “Global Golden Rule” framework, which we will revisit in next week’s Strategy Report. For now, however, we see a strong case to turn more positive on UK Gilts, with the BoE likely to deliver fewer rate hikes than discounted (Chart 13). The BoE is also far less likely to begin reducing its balance sheet by selling its Gilt holdings back to the market. BoE Governor Bailey strongly hinted last week that such aggressive quantitative tightening (QT) was not a given, even after the Bank research staff presents its proposals to the MPC in August. A delay in QT would also be a factor boosting UK Gilt performance versus other developed economy bond markets where more aggressive reductions in central bank balance sheets are more likely, like the US and potentially even the euro area. This week, we are upgrading our recommended strategic UK weighting from underweight to overweight. In next week’s report, we will consider the proper allocation for the UK within our model bond portfolio, after reviewing potential bond return forecasts stemming from our Global Golden Rule. Bottom Line: Markets are overestimating how much additional tightening the Bank of England can deliver. We are upgrading our recommended strategic stance on UK Gilts from underweight (2 out of 5) to overweight (4 out of 5). Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Footnotes 1      The mechanical way that the UK government’s energy price regulator, Ofgem, sets price caps on retail gas and electricity costs - based on changes in wholesale energy costs implied by futures curves – means that UK household energy prices will rise by 40% in October, according to BoE estimates. GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark It’s Time To Flip The Script - Upgrade UK Gilts It’s Time To Flip The Script - Upgrade UK Gilts The GFIS Recommended Portfolio Vs. The Custom Benchmark Index It’s Time To Flip The Script - Upgrade UK Gilts It’s Time To Flip The Script - Upgrade UK Gilts Tactical Overlay Trades

Executive Summary Ingredients For A Policy Mistake Ingredients For A Policy Mistake Ingredients For A Policy Mistake The hawks on the European Central Bank Governing Council have become vocal about a July rate hike. Such a move would be a policy mistake because European growth is weak, while inflation is supply-driven and will soften meaningfully. July 2022 hike is not yet certain. A policy mistake suggests that the current interest rate pricing for June 23 is too aggressive. Buy June 2023 Euribor contract. The serious risk of a policy mistake and the uncertainty surrounding Europe’s energy security confirm that investors should maintain a defensive stance in European assets. The pronounced threats to UK growth warrant a negative view on the pound.   Recommendation INCEPTION DATE RETURN SINCE INCEPTION (%) COMMENT Buy June 2023 Euribor contract 05/09/2022     Bottom Line: Stay defensive in Europe. The risk of a policy mistake is high. Only when inflation peaks should investors move into cyclical stocks.   In recent weeks, a chorus of ECB hawks expressed the need to increase rates as early as July 2022. Inflation data is on their side; HICP stands at 7.5% and core CPI has reached 3.5%, levels never seen since the introduction of the euro. Markets are responding. The ESTR curve is pricing in a positive ECB deposit rate for the October 2022 Governing Council meeting. We need to examine the underlying European economic picture to address two key questions: Will the ECB lift rates as early as July? And will doing so constitute a policy mistake that would hurt European assets? Weaker Growth Let’s start with the growth outlook. European economic activity is rapidly deteriorating. Real GDP growth in the Eurozone has slowed markedly. In Q1, real GDP growth fell to 0.2% quarter-on-quarter or an annualized rate of 0.8%. Worrisomely, Italy’s GDP contracted by -0.2% over that time frame and the very economically sensitive Swedish activity contracted by -0.4%, which suggests that Europe’s deceleration is only starting. Soft data confirm the flagging economic outlook on the continent. Consumer confidence is plunging to levels that are consistent with a recession, led by the collapse in the willingness to make large purchases (Chart 1, top panel). The ZEW as well as the Ifo survey confirm that growth expectations point to a very large decline in output (Chart 1, bottom panel). The weakness is also evident in hard data. High inflation erodes real household income, which squeezes consumer spending. Retail sales across Europe are slowing sharply, only growing at an annual rate of 0.8% while contracting -0.4% on a monthly basis; on a level basis, they are lower today than they were in June 2021. Meanwhile, German retail sales volumes are falling at a -5.4% annual rate. The situation is even worse for new car registrations, which are collapsing at an annual rate of 20.2% (Chart 2). Chart 1Soft Data Point To Soft Growth... Soft Data Point To Soft Growth... Soft Data Point To Soft Growth... Chart 2...So Do Hard Data ...So Do Hard Data ...So Do Hard Data Industrial production has not been spared. Euro Area IP softened to 2% annually in February and contractions are now visible in Germany and France. Some of this weakness reflects supply difficulties, but the -3.1% annual fall in German factory orders indicates that demand is frail too and that industrial production will shrink further in the months ahead (Chart 2, bottom panel). The deterioration in the global outlook further hurts Europe economic prospects. Our global growth tax indicator, based on energy prices, the dollar, and global bond yields, points toward a further deceleration in the global and US manufacturing PMI, it suggests Euro Area PMIs could fall below 50 (Chart 3). China woes continue to reverberate throughout the global economy. Potential supply constraints will hurt industrial production, but, more importantly, the weakness in China’s marginal propensity to consume (as measured by the gap between the growth rate of M1 relative to M2) predicts a much greater deterioration in European industrial orders, which means that the demand for European capital goods will slow (Chart 3, bottom panel). Chart 3Risks To The Downside Risks To The Downside Risks To The Downside Chart 4Tightening Financial Conditions Tightening Financial Conditions Tightening Financial Conditions European financial conditions are also tightening significantly. The iTraxx Crossover Index is rising swiftly. European high-yield corporate spreads are now above 450bps, levels that coincide with past recessions in the Euro Area (Chart 4). Government bond markets are increasingly under duress too. Italian BTPs now yield close to 200bps above German Bunds (Chart 4, bottom panel), which accentuates the periphery’s pain. Bottom Line: The Eurozone economy is slowing sharply. While Q1 GDP avoided a contraction, soft and hard data indicators suggest that Q2 is likely to record an actual output contraction for the whole Euro bloc. High Inflation, But For How Long? At first glance, European inflation numbers scream for an ECB rate hike, preferably one yesterday. However, the picture is not that clear-cut. Supply factors predominantly drive the Eurozone’s inflation surge. Chart 5 highlights the role of energy, utilities, food, and transportation costs in the HICP and shows that these factors account for more than 80% of the 7.5% HICP rate. Moreover, the fluctuations in energy CPI continue to explain most of the gyration in headline CPI. The close relationship between energy CPI and core CPI highlights an elevated degree of pass-though, the result of higher electricity and transportation costs (Chart 6). Chart 5Energy, Food And Transport Dominate European CPI An ECB Policy Mistake And Your Portfolio An ECB Policy Mistake And Your Portfolio Chart 6All About Energy All About Energy All About Energy Chart 7No Demand Pull-Inflation In Europe No Demand Pull-Inflation In Europe No Demand Pull-Inflation In Europe Unlike those in the US, Euro Area underlying inflation drivers are weak and inconsistent with demand-pull inflation. Wage growth in Europe stands at a paltry 1.6% annual rate, while in the US, the Atlanta Fed Wage Tracker has jumped to 4.5% (Chart 7, top panel). Moreover, Eurozone rent inflation remains stable at 1.2%, while it is a very elevated 4.5% in the US (Chart 7, bottom panel). The bifurcation in demand-driven inflation reflects vastly different output gaps between the two regions. US nominal GDP stands 2.5% above its 2014-2019 trend, while that of the Eurozone is still 5.3% below it. In the consumer durable goods sector, where the US experienced the greatest demand-supply mismatch – and therefore, the greatest inflation pressures – purchases are 25% above their 2014-2019 trend, while in Europe, they are still 9.5% below that trend (Chart 8) Year-on-year inflation prints should roll over this summer, as highlighted by weakening sequential inflation. Even if it remains elevated, the monthly Trimmed Mean CPI peaked last year. Energy inflation, moreover, is already contracting on a month-to-month basis (Chart 9). Chart 8Mind The Output Gap Mind The Output Gap Mind The Output Gap Chart 9Weakening Sequential Inflation Weakening Sequential Inflation Weakening Sequential Inflation Chart 10A Naive Inflation Forecast A Naive Inflation Forecast A Naive Inflation Forecast Simple simulation exercises also confirm that annual inflation will peak this summer (Chart 10). Monthly headline inflation averaged 0.11% from 2010 to 2019, 0.31% in the first half of 2021, and 0.55% from mid-2021 to January 2022. If we assume that monthly inflation prints remain in line with its most recent average, annual inflation will peak by year-end at 9.1%, before falling to 6.8% by April 2023. However, if monthly inflation falls back to an historically elevated monthly average of 0.31%, annual headline inflation will peak in September and fall back to 3.8% by April 2023. Similarly, if monthly core CPI averages 0.28%, annual core CPI will peak in October before declining to 3.4% by April 2023, but it will fall to 2.1% by April 2023, if monthly core CPI averages an historically elevated 0.17%, or the average observed in the first half of 2021 (Chart 10, bottom two panels). Chart 11A Conditional Inflation Forecast A Conditional Inflation Forecast A Conditional Inflation Forecast A more sophisticated exercise based on energy prices and the EUR/USD exchange rate also underlines the downside for Euro Area headline inflation. Energy inflation, which drives headline CPI, closely tracks the evolution of brent prices in euro terms and Deutsch natural gas prices. Assuming that natural gas prices average the historically very high level of €100/MWh over the next twelve months, that Brent averages US$95/bbl over that time frame (consistent with BCA’s commodity and energy team forecasts), and that the euro progressively moves back to EUR/USD1.10 by April 2023 (a weaker expectation than BCA’s Foreign Exchange Strategy team  anticipates), then the Eurozone’s energy inflation will collapse to -10% by April 2023 (Chart 11). We can also assume that Russia enacts a full energy embargo on Western Europe if Sweden and Finland apply for NATO membership. In this case, Brent would spike quickly to $140/bbl and natural gas to €250/MWh. In our scenario, prices stay elevated for two months, before they ultimately normalize by early 2023. Under this scenario, energy inflation would experience a spike to 80% (!) in June 2022 before falling back sharply. In all cases, the collapse in energy inflation is consistent with a rapid decline in headline inflation toward 2% in 2023. Bottom Line: European inflation is elevated but remains mainly driven by supply factors, particularly the evolution of energy inflation. Demand-pull inflation is minimal, unlike that in the US. Additionally, both core and headline inflations are set to peak in the coming months based on the evolution of sequential monthly inflation as well as the behavior of the energy market. A July ECB rate hike would constitute a policy mistake for three reasons: (i) the ECB has no control over supply-driven inflation; (ii) Eurozone inflation is set to weaken; and (iii) economic growth will remain poor. Investment Implications Despite the noise made by the hawks, a large amount of uncertainty around the July 2022 meeting’s outcome remains. It is easy to forget that the ECB’s decisions are consensual. Influential members such as Vice-President Luis de Guindos continues to see a July 2022 hike as possible but unlikely. Others, such as Executive Board member Fabio Panetta, are very worried about the Eurozone’s economic slowdown. Moreover, ECB President Christine Lagarde has not endorsed the hawks. In the context of weak growth and a potential top in inflation, achieving consensus about an early summer hike could be difficult. Chart 12Patience Would Be Rewarded Patience Would Be Rewarded Patience Would Be Rewarded The great paradox is that, if the ECB waits before pushing interest rates up, it will have an opportunity to increase rates durably next year. Wage growth is anemic today, but the decline in the Eurozone unemployment rate is consistent with a pickup in salaries in 2023 (Chart 12). Moreover, if energy inflation slows, the relative price-shock that is hurting households and domestic demand will ebb, which will allow consumption to recover. Patience would give Europe strength and the ECB a very strong basis to lift rates sustainably. The hawks will sway the council to their views. Inflation has latency, which means that its inertia may cause HICP to remain elevated beyond this summer. Moreover, the EU’s proposed ban on Russian oil imports along with Sweden’s and Finland’s likely accession-demand to NATO in the upcoming weeks could provoke Russia to strike first by cutting all its energy export to the EU to zero immediately. This would lift inflation for somewhat longer, as we showed in Chart 9. Related Report  European Investment StrategyThe Three Forces Hurting European Earnings In response to the significant risk of a rate hike, we continue to recommend investors stay short cyclical stocks relative to defensive ones. Moreover, if the risk of a Russian energy cutoff increases, so does the threat of a severe recession in Europe, as a recent Bundesbank study posits (Chart 13). Capital preservation is paramount in today’s context; thus, we continue to lean on the side of prudence, especially considering Europe’s soft profit outlook. Once risks recede, we will abandon this strategy. This decision, however, would require clarification of Sweden and Finland’s decision about their membership in NATO as well as Russia’s response, a confirmation that the ECB is not hiking rates in July, and a pullback in inflation surprises, which would prove a powerful help for European equities and the cyclicals/defensive split (Chart 14). Chart 13The Russian Embargo Risk An ECB Policy Mistake And Your Portfolio An ECB Policy Mistake And Your Portfolio Chart 14Wait For Inflation To Turn Wait For Inflation To Turn Wait For Inflation To Turn In fact, our view that inflation will peak leads to direct implications for European markets. The periods that followed the previous four peaks in European core inflation were associated with an outperformance of small-cap stocks and cyclical stocks over the subsequent six and twelve months as well as declines in German yields and narrower credit spreads (Table 1A). The sectoral implications were not as clear, but industrials enjoyed an edge, while healthcare stocks suffered marked declines. Our conviction is strongest that energy CPI will fall. Again, this environment is associated with an outperformance of small-caps stocks and cyclicals over the following six months (Table 1B). Sector-wise, energy names suffer in this climate along with defensives, especially communication services equities. Table 1APeaks In Core CPI & Subsequent European Asset Performance An ECB Policy Mistake And Your Portfolio An ECB Policy Mistake And Your Portfolio Table 1BPeaks In Energy CPI & Subsequent European Asset Performance An ECB Policy Mistake And Your Portfolio An ECB Policy Mistake And Your Portfolio Looking at this period of disinflation more broadly rather than just following peaks in inflation, we find similar results. Declining core CPI is associated with an outperformance of cyclicals relative to defensives as well as strength in small-cap equities (Table 2A). This larger sample allows for a clearer view of sectors. Specifically, the performance of industrials and tech relative to the broad market improves markedly, while utilities suffer greatly. We reach roughly similar conclusions when energy CPI is contracting, except that, in this instance, energy stocks also underperform (Table 2B). Interestingly, so do financial companies. This is a surprising result, but previous instances of weaker energy CPI in the sample reflected weaker demand, not an evolving supply shock. Weaker aggregate demand always hurts financials.  Table 2ADisinflation & Subsequent European Asset Performance An ECB Policy Mistake And Your Portfolio An ECB Policy Mistake And Your Portfolio Table 2BEnergy Deflation & Subsequent European Asset Performance An ECB Policy Mistake And Your Portfolio An ECB Policy Mistake And Your Portfolio Bottom Line: The risk of a policy mistake at the July ECB meeting is elevated. A policy mistake suggests that the current interest rate pricing for June 23 is too aggressive. Buy June 2023 Euribor contract. Moreover, Russian energy exports are still under threat. Accordingly, we continue to emphasize capital preservation and favor defensives over cyclicals. However, a buying opportunity will emerge rapidly once inflation peaks, especially if the ECB follows our base case. At this point, investors should buy small-cap and cyclical stocks. Industrials will beat energy, while all the defensive sectors will suffer. The BoE’s Tough Choice The Bank of England is stuck between a rock and a hard place. UK inflation shares characteristics of that of both the Eurozone and the US. On the one hand, energy inflation is increasing and could push headline CPI into double-digit territory around October 2022, once fuel subsidies fully expire. On the other hand, wage growth is strong as labor supply elasticity declined after Brexit. Demand-pull inflation is also rampant, which has pushed core CPI to a 5.7% annual rate. The UK’s cost push inflation, along with the growth slowdown in Europe and increasing tax rates are likely to cause a recession in the UK over the coming twelve months. The demand-pull inflation, however, will force the BoE to hike interest rates. This accentuates the downside risk to UK economic activity. Chart 15BoE's First Victim: The Pound BoE's First Victim: The Pound BoE's First Victim: The Pound The obvious victim of this configuration is the pound. Weak growth will prevent the BoE from matching the pace of rate hikes of the Fed and poor economic growth will detract from investments in the UK. As a result, we see further downside in GBP/USD (Chart 15). BCA’s FX strategy team is also selling the pound versus the euro. This position is likely to generate further gains as investors will revise down their views for UK economic activity relative to the Euro Area, since they already hold much more dire expectations for the latter than the former. Bottom Line: EUR/GBP possesses more upside. The growth outlook for the Eurozone is poor, but investors currently overestimate the growth path of the UK relative to that of its southern neighbor.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations

Executive Summary The Dollar Has Broken Above Overhead Resistance The Dollar Has Broken Above Overhead Resistance The Dollar Has Broken Above Overhead Resistance Most central banks continue to dial up their hawkish rhetoric, led by the Fed. This is putting upward pressure on the dollar (Feature Chart). The big surprise has been resilient inflationary pressures across many economies. In our view, the market has already priced in an aggressive path for interest rates in the US, putting the onus on the Fed to deliver on these expectations. Meanwhile, other central banks that are also facing domestic inflationary pressures will play catch up. Our short USD/JPY position was triggered at 124. While there are no immediate catalysts for yen bulls, the currency is very cheap, and speculators are very short. Look to sell the DXY soon. RECOMMENDATIONS INCEPTION LEVEL inception date RETURN Short DXY 102 2022-04-07 - SHORT USD/JPY 124 2022-04-05 0.02 Bottom Line: Technically, the dollar has broken above overhead resistance, putting it within striking distance of the March 2020 highs at 103. However, given stretched positioning, our bias is that incremental increases in the DXY will require much more upside surprises in US interest rates. This is not our base case. Feature The dollar performed well in the first quarter of this year. Year-to-date, the DXY index is up 3.9%.  Remarkably, this has coincided with strength in many commodity currencies such as the BRL, ZAR, COP, CLP, and AUD, that tend to be high beta plays on a falling dollar (Chart 1). Technically, the dollar has broken above overhead resistance, putting it within striking distance of the March 2020 highs of 103 (Chart 2). However, given stretched positioning, our bias is that incremental increases in the DXY will require much more upside surprises in US interest rates. This is not our base case. Chart 1The Dollar And Commodity Currencies Have Been Strong This Year Month In Review: A Continued Hawkish Shift Month In Review: A Continued Hawkish Shift Chart 2The Dollar Has Broken Above Overhead ##br##Resistance The Dollar Has Broken Above Overhead Resistance The Dollar Has Broken Above Overhead Resistance As we have highlighted in past reports, the dollar continues to face a tug of war. If rates rise substantially in the US, and that undermines the US equity market leadership (Chart 3), the dollar could suffer. If US rates rise by less than what the market expects, record high speculative positioning in the dollar will surely reverse. Chart 3Dollar Tailwinds Remain Intact Dollar Tailwinds Remain Intact Dollar Tailwinds Remain Intact This week’s Month-In Review report goes over our take on the latest G10 data releases, and the implication for currency strategy both in the near term and longer term. US Dollar: The Fed Stays Hawkish Chart 4The Case For More Tightening The Case For More Tightening The Case For More Tightening The dollar DXY index is up 3.9% year-to-date. The key data releases the Federal Reserve watches continue to suggest a hawkish path for interest rates going forward. Inflation remains strong in the US. Headline CPI came in at 7.9% year-on-year in February and is expected to accelerate in next week’s release. Nonfarm payrolls are still robust. The US added 431K jobs in March, nudging the unemployment rate to a cycle low of 3.6%. Wages are inflecting higher, which is pulling up unit labor costs. The Atlanta Fed Wage Growth Tracker currently sits at 6%. These developments continue to underpin market expectations for aggressive interest rate increases. The market now expects the Fed to raise rates to 2.25% by December 2022. Speculators are also very long the dollar. The mispricing in the dollar comes from the fact that markets are expecting the Fed to be more aggressive than other central banks in curtailing monetary accommodation this year (as proxied by two-year yield spreads). However, the reality is that other central banks are also ratcheting up their hawkish rhetoric. As such, we expect policy convergence to be a theme that will play out in 2022, putting downward pressure on the dollar. In conclusion, our 3-month view on the dollar is neutral, based on the risk of further escalation in the Ukrainian crisis and robust inflation prints, but our 9-month assessment will be to sell the dollar on any strength. We are revising our year-end target on the DXY to 95. The Euro: Stagflation Chart 5Euro Area Real Yields Are Too Low Euro Area Real Yields Are Too Low Euro Area Real Yields Are Too Low The euro continues to weaken, down 4.2% this year, after hitting an intraday low of 1.08 last month. Economic data in the eurozone has been soft, especially on the back of a surge in the number of new Covid-19 cases, rising energy costs driven by the military conflict between Ukraine and Russia, and a weak euro adding to upward pressure on inflation. This is pinning the euro area in a stagflationary quagmire.  More specifically: The headline HICP (harmonized index of consumer prices) index for the euro area was 7.5% for March. The hawks in the ECB are very uncomfortable with last week’s HICP release of 9.8% in Spain, 7.3% in Germany, and 7% in Italy. House prices in the euro area are accelerating on the back of very low real rates. This is increasing the unaffordability of homes across the eurozone. One of our favorite measures of economic activity, the Sentix Economic Index, tumbled in April. At -18, this is the lowest since July 2020, a negative surprise vis-à-vis the expected -9.4. Faced with a deteriorating economic backdrop, but strong inflationary pressures, the ECB has chosen a hawkish path to maintain credibility. Asset purchases will be tapered this year, and rate hikes are on the table. Forward markets are now pricing 53 bps of interest rate increases this year. In our view, while the ECB will not deliver the pace of rate hikes anticipated by markets in the near term, pricing of interest rate differentials between the eurozone and the US will narrow, as the ECB plays catch up. We are neutral on the euro over a 3-month horizon but are buyers over 9 months and beyond. Stay long EUR/GBP as a play on policy convergence between the ECB and BoE. Our year-end target for EUR/USD is 1.18.  The Japanese Yen: A Contrarian View Chart 6Too Many Yen Bears Too Many Yen Bears Too Many Yen Bears The Japanese Yen: A Contrarian View The Japanese yen is down 7% year-to-date. This pins it as the worst performing G10 currency this year. The story for Japan (and the yen) has been a very slow emergence from the latest Covid-19 wave. This has kept domestic inflation very subdued, allowing the BoJ to stay dovish, even as the external environment has done better. This has pushed interest rate differentials against the Japanese yen. The latest trigger for the selloff in the yen was the BoJ’s commitment to maintain yield curve control as global interest rates have been surging. This pushed USD/JPY above 125, the highest since 2015. On the back of this move, incoming economic data justified the BoJ’s stance. Headline inflation has picked up (still at 0.9%), but core “core” inflation remains at -1%. At 1.21, the job-to-applicant ratio is well below its pre-pandemic level of around 1.6. Ergo, the labor market is not as tight as a 2.7% unemployment rate suggests. Wage growth is improving, currently at 1.2% for February. That said, is it hard to argue that Japanese workers have bargaining power and can trigger a wage/inflation spiral that will allow the BoJ to pivot. Related Report  Foreign Exchange StrategyThe Yen In 2022 Despite these negatives, we are constructive on the yen because the downside is well priced in, while upside surprises are not. Real rates remain higher in Japan than for other G10 countries. Speculators are also very short the yen. As we highlighted last week, the yen is also extremely cheap. We went short USD/JPY at 124. Our view is that interest rate expectations for the US are overdone in the near term. As such a stabilization/retracement in global yields could be a bullish development for yen bulls. Our target is 110 with a stop at 128.  British Pound: A Hawkish BoE Chart 7The Case For A Hawkish BoE The Case For A Hawkish BoE The Case For A Hawkish BoE The pound is down 3.4% year-to-date. The Bank of England has been one of the more aggressive central banks, raising interest rates to 0.75% last month. Inflation continues to soar in the UK - headline CPI was at 6.2% in February while core inflation clocked in at 5.2%. This prompted the governor to send a letter to the Chancellor of the Exchequer, explaining why monetary policy has allowed inflation to deviate from the BoE’s mandate of 2%. According to the BoE’s projections, inflation will rise above 8% this year before peaking. At the same time, taxes are slated to rise in the UK this month. While the labor market continues to heal, the combination will be a hit to consumer sentiment in the near term. The SONIA curve in the UK is pricing 130 bps of price hikes this year. While the BOE must contain inflationary pressures (in accordance with their mandate), the risks of a policy mistake have risen. Tight monetary and fiscal policy in the UK could stomp out any budding economic green shoots. The pound is also very sensitive to global financial conditions, and an equity market correction, especially on the back of heightened tensions in Ukraine, will put pressure on cable. We are short sterling, via a long EUR position. In our view, the EUR/GBP cross is heavily underpricing the risks to the UK economy in the near term.    Australian Dollar: A Commodity Story Chart 8The RBA Will Stay Patient The RBA Will Stay Patient The RBA Will Stay Patient The Australian dollar is up 3% year-to-date, making it the best performing G10 currency. The Reserve Bank of Australia kept rates on hold at its April 5th meeting, but it ratcheted up its hawkish tone. The two critical measures that the RBA is focusing on, inflation and wages, have been improving. As a result, the shift in the RBA stance was justified. Since its March meeting, home prices have continued to accelerate, rising 23.7% year-on-year in Q4. Meanwhile, the unemployment rate has fallen to a cycle low of 4% in Q4. This is below many measures of NAIRU. The RBA expects inflationary pressures to remain persistent in 2022, but ultimately fall to 2.75% in 2023. This will still be at the upper bound of their 2%-3% target range. Admittedly, wages are still low by historical standards, but as Governor Philip Lowe has highlighted, the behavior of the Phillip’s Curve at these low levels of unemployment is unpredictable. The external environment is also AUD bullish. The RBA Index of Commodity prices soared by 40.9% year-on-year in March, widening the gap with a rather muted AUD (up 3.4% this year). In our view, the market is concerned about the zero-Covid policy in China (Australia’s biggest export partner), which could dim Australia’s economic outlook in the near term. On the flip side, many speculators are now short the Aussie which is bullish from a contrarian perspective. A healthy trade balance is also putting upward pressure on the currency. We are lifting our limit buy on AUD/USD to 72 cents, after being stopped out for a modest profit earlier this year.  New Zealand Dollar: Positive Catalysts, But Overvalued Chart 9Home Price Inflation In New Zealand Is Rolling Over Home Price Inflation In New Zealand Is Rolling Over Home Price Inflation In New Zealand Is Rolling Over The New Zealand dollar is up 1% year-to-date. The Reserve Bank of New Zealand is among the most hawkish within the G10.  The cash rate is at 1%, the highest among major developed economies on the back of economic data which remains robust. Home prices, a metric the RBNZ monitors to calibrate monetary policy, are rising 23.4% year-on-year as of March. While we are modestly positive on the Kiwi, it has become very expensive according to most of our models. The result is that the trade balance continues to print a deficit, with the latest data point in February deteriorating to NZ$ -8.4 billion. Kiwi bonds also offer the highest yield in the G10, meaning the market has already priced a hawkish path of interest rates by the RBNZ. Given the crosscurrents mentioned above, we are neutral the kiwi versus the dollar over both a 3-month and 9-month horizon.          Canadian Dollar: The BoC Will Stay Hawkish Chart 10The BoC Will Hike Next Week The BoC Will Hike Next Week The BoC Will Hike Next Week The CAD is up 0.4% year-to-date. The Bank of Canada is expected to raise interest rates by 50bps to 1% at next week’s meeting. This is not a surprise, since all the measures the BoC looks at to calibrate monetary policy are robust. Both headline and core inflation are well above the midpoint of the 1%-3% target range. The common, trim, and median inflation prints are either at or above the upper bound of the central bank’s target at 2.6%, 4.3%, and 3.5%, respectively. This suggests inflationary pressures in Canada are broad based. Employment in Canada is back above pre-pandemic levels, with the unemployment rate slated to come in at 5.4% with today’s release, close to estimates of NAIRU. House price inflation is raging across many cities in Canada, which argues that monetary policy is too easy and mortgage rates are too low. We have always highlighted that the key driver of the CAD remains the outlook for monetary policy and the path of energy prices. In the near term, oil prices will stay volatile as the situation in Ukraine continues to be very fluid, but the CAD has not priced in the fact that the BoC is leading the interest rate cycle vis-à-vis the US this time around.  Speculators are only neutral the CAD, an appropriate stance over the next three months. That said, we are buyers of CAD over a 9-to-12-month horizon, with a target of 0.84.   Swiss Franc: A Safe Haven Chart 11The SNB Will Lean Against Franc Strength The SNB Will Lean Against Franc Strength The SNB Will Lean Against Franc Strength The Swiss economy continued to fare well in the first quarter. The manufacturing PMI jumped to 64 in March. Retail sales were up 12.8% year-on-year in February. The labor market remains strong with unemployment near pre-pandemic levels. Switzerland’s direct exposure to the war appears relatively limited with little inflationary spillovers. CPI stood at 2.4% year-on-year in March, with about 1% of the increase coming from energy prices. The Swiss economy is still generating a record trade surplus, coming in at CHF 5.7bn in February. Safe-haven inflows into the franc have dampened inflationary dynamics. This leaves room for the SNB to continue easing monetary policy for longer relative to other central banks in the developed world.  In terms of monetary policy, the SNB kept interest rates unchanged at -0.75% at its Q1 meeting. The SNB has also described the franc as “highly valued” and said that it is willing to intervene in FX markets as necessary to counter the upward pressure in the currency. Sight deposits have been rising in March. We are neutral CHF on both a 3-month and 9-month horizon but will be buyers of EUR/CHF at current levels.   Norwegian Krone: Bullish On A 12-18 Month Horizon Chart 12NOK Has A Policy Tailwind NOK Has A Policy Tailwind NOK Has A Policy Tailwind The NOK is flat this year. In March, the Norges Bank raised the policy rate by 25 bps to 0.75%, in line with policymakers’ previous statements. Citing rising import prices and a tight labor market, the committee now expects to increase rates to 2.5% by the end of 2023, up from an assessment of 1.75% in December.  Inflation accelerated again in February, with headline and core CPI at 3.7% and 2.1% year-on-year respectively. Despite the removal of all Covid-19 restrictions in mid-February, consumer demand data remained soft with retail sales, household consumption, and loan growth all down in February. Still, the overall economy remains strong, and the Bank expects a rebound in demand going forward. The manufacturing PMI jumped to 59.6 in March after a three-month decline. Industrial production rose 1.6% year-on-year in February, after lackluster performance in January. The trade surplus remains robust. Registered unemployment fell to 2% in March and with rising wage expectations, the case for tighter monetary policy remains intact. The uncertainty over energy-related sanctions can keep oil prices volatile in the near time, as well as the NOK. That said, our commodity team expects oil to average $93/bbl next year, which is higher than what the forward markets are pricing. That will be bullish for the NOK.   Swedish Krona: Lower Now, Strong Later Chart 13The SEK Is Not Pricing Rate Hikes By The Riksbank The SEK Is Not Pricing Rate Hikes By The Riksbank The SEK Is Not Pricing Rate Hikes By The Riksbank SEK is down 4% year-to-date. The Riksbank remains one of the most dovish central banks in the G10, keeping the repo rate at 0% at its February meeting, with no hikes projected until 2024. Since then, inflation data has come in well above expectations and several board members have spoken out on the need to reevaluate monetary policy. The OIS curve is now pricing about two hikes by the end of the year. CPIF was 4.5% year-on-year in February and the measure excluding energy jumped to 3.4%, up from 2.5% in January. With fears that the conflict in Ukraine will exacerbate this trend, a survey of 12-month inflation expectations stood at a record 10.2% in March. While inflation is surprising to the upside, underlying economic data has been on the weaker side. The Swedish new orders-to-inventory ratio has fallen sharply. Consumer confidence also dipped in March, to the lowest point since the Global Financial Crisis. Sweden remains highly sensitive to eurozone economic conditions. As such, it is also in the direct firing range of any economic turbulence in the euro area, though it will also benefit from growth stabilization later this year, should macroeconomic risks abate. SEK is the second most undervalued currency based on our Purchasing Power Parity models and is likely positioned for a coiled spring rebound when the Riksbank eventually turns more hawkish. We are neutral SEK over a 3-month horizon but are bullish longer term.    Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary

Executive Summary The Dollar And The Yield Curve The Dollar And The Yield Curve The Dollar And The Yield Curve The dollar has tended to decline 3-to-6 months after the Fed starts hiking interest rates. This has been true since the mid-1990s. Beyond that timeframe, the path of the dollar has depended on what other central banks are doing, and/or which stage of the business cycle we are in. The flattening yield curve in the US is coinciding with a strong dollar (Feature chart), but the historical evidence is that this relationship is very fickle. While the dollar tends to rise during recessions, the average business cycle over the last 40 years has also lasted 90 months, making a recession in the next year possible, but not probable. The dollar has usually followed a long boom/bust cycle of 10 years. If the Fed stays behind the inflation curve, we could be entering a period of weakness akin to the pre-Volcker years in the 70s. The greenback has also tended to be seasonally strong in H1 and weaker in H2. The yen has generally been the best-performing currency shortly after a Fed rate hike. Go short USD/JPY if it touches 124. RECOMMENDATION INCEPTION LEVEL inception date RETURN Short USD/JPY 124 2022-04-01 - Bottom Line: Our bias remains that the DXY index does not have much upside above 100. Our 12-month target remains 90. Feature Chart I-1Dollar Action Before Curve Inversions Is Mixed Dollar Action Before Curve Inversions Is Mixed Dollar Action Before Curve Inversions Is Mixed Rudi Dornbusch was one of the pioneers behind the theory that currency markets tend to overreact. His observation was as simple as it was brilliant. Currency markets are fluid, while prices tend to be sticky. Therefore, a monetary response to an inflation overshoot will initially cause a knee-jerk reaction in the currency before it settles back towards equilibrium. While we have oversimplified Dornbusch’s overshooting model, it is hard to ignore the fact that today’s currency and bond markets could potentially be overreacting. The 10-year/2-year US Treasury spread briefly turned negative this week, as the short end catapulted higher. Historically, that has been a precursor to an impending recession. This is important because the dollar has usually done well during recessions, even though its performance ahead of doomsday has been mixed over a 40-year period (Chart I-1). Given this backdrop, this report attempts to answer a few questions. How has the dollar performed over prior Federal Reserve tightening cycles? What drives the relationship between the dollar and the yield curve? Are the Fed rate hikes currently priced in the short end of the curve credible? Which currencies have historically excelled or suffered once the Fed begins to tighten policy? And finally, what is the roadmap investors should use to gauge the path of the dollar going forward? The Dollar And The Yield Curve Chart I-2A Rising Dollar Has Tracked A Flattening Curve A Rising Dollar Has Tracked A Flattening Curve A Rising Dollar Has Tracked A Flattening Curve The relationship between the dollar and the yield curve has been tight over the last three years. A flattening curve throughout most of 2018 signaled US policy was getting too restrictive relative to underlying economic conditions. The dollar was also rising (Chart I-2). The Federal Reserve eventually responded by cutting rates, which allowed the curve to steepen again, eventually putting a top in the greenback. Our Chief US Bond Strategist, Ryan Swift, has characterized this cycle as the dollar/bond feedback loop (Chart I-3).    Chart I-3The Dollar/Bond Feedback Loop Lessons From Fed Interest Rate Hikes Lessons From Fed Interest Rate Hikes In retrospect, this feedback loop works through two channels. First, almost 90% of global transactions are conducted in US dollars, which means the cost of doing business (paying for imports, reconciling accounts payables, servicing debt, and so on) rises for foreigners as the dollar appreciates. This puts a break on economic activity abroad. Second, as a counter-cyclical currency, the dollar tends to attract capital when growth in the rest of the world is slowing, reinforcing this loop. Eventually, a strong dollar and rising domestic bond yields put a break on US economic activity, which causes the Fed to back off. Investors with a high-conviction view that we are close to a recession should be buying the dollar on weakness. In our view, many central banks are becoming too hawkish at the exact moment global growth is set to slow. That said, not unlike the Dornbusch analogy at the start of this text, currency markets have overreacted. Specifically: Over the last 40 years, the average business cycle has lasted 90 months. An inverted yield curve does not corroborate this fact, considering the recession in 2020. It is well known that there are previous episodes of the yield curve inverting, without an impending recession. This time around, rate hike expectations have been heavily priced at the front end of the curve, while being underpriced at the long end. The inference is that the market thinks the Fed is about to make a policy mistake. With policy rates in the US still at 25-50 bps, those near-term rate expectations will turn out to be wrong if US economic growth does indeed slow, forcing the Fed to pivot. The term premium in the US (and globally) is very low, and could rise as quantitative easing is wound down, and yield-curve control is relaxed in bond markets such as Japan. That could help lift longer-term bond yields. Global yield curves have tended to move in unison, with the UK curve historically being the first to invert ahead of a recession. That has not yet happened. Elsewhere, Japanese, and German yield curves are steep (Chart I-4). Chart I-4Global Yield Curves Tend To Move In Unison Global Yield Curves Tend To Move In Unison Global Yield Curves Tend To Move In Unison Historically, the relationship between the yield curve and the dollar has not been consistent (Chart I-5). In the early 80s, the dollar initially rose with a steepening yield curve. In retrospect, rising real rates at the long end of the Treasury curve drove the initial dollar rally. The backdrop was Federal Reserve Chairman Paul Volcker’s resolve to crack down on inflation. Thereafter, rising trade imbalances on the back of a strong dollar eventually led to the Plaza Accord in 1985, which weakened the dollar despite a curve that remained steep. In the 1990s, the dollar rose along with a flattening curve and a productivity boom in the US. In both the latter half of the 2000s and 2010s, the curve flattened, but the performances of the dollar in each case were opposites - weakness in the 2000s, but strength over the last decade. Chart I-5No Consistent Relationship Between The Dollar And The Yield Curve No Consistent Relationship Between The Dollar And The Yield Curve No Consistent Relationship Between The Dollar And The Yield Curve The bottom line is that the dollar tends to do well during recessions, which historically has happened after the yield curve inverts. Prior to that, the performance of the dollar is mixed. Dollar Performance Over Prior Tightening Cycles Chart I-6The Dollar Falls After The First Fed Rate Hike The Dollar Falls After The First Fed Rate Hike The Dollar Falls After The First Fed Rate Hike The dollar has tended to decline 3-to-6 months after the Fed starts hiking interest rates. This has been true since the mid-1990s (Chart I-6). The average decline after six months has been 5.3%. This will pin the DXY at around 95 or so by late summer. As the Appendix  shows, while this relationship has been consistent for the dollar, it has been inconclusive for the hiking cycles of other central banks. The exceptions are the CAD, GBP, and SEK which tend to rally three months after their respective central banks raise rates. The AUD initially stalls but performs well one year after the Reserve Bank of Australia lifts interest rates. There is a rationale as to why the dollar performs well ahead of interest rate increases by the Fed, and falters shortly after. Historically, the Fed has usually been the first to start the process of hiking interest rates globally. It has also been the central bank that has lifted rates by the most (Chart I-7). This history of credibility has nudged forward markets to grow accustomed to anticipating the Federal Reserve to be ahead of the curve. As of now, US policy rates stand at 0.25% but the two-year yield is at 2.4%. This divergence could be viewed as vote of credibility akin to during the Volcker years (Chart I-8). Chart I-7The Fed Has Usually Led The Hiking Cycle The Fed Has Usually Led The Hiking Cycle The Fed Has Usually Led The Hiking Cycle Chart I-8The 2-Year/3-Month Treasury Spread Is Very Wide The 2-year/3-month Treasury Spread Is Very Wide The 2-year/3-month Treasury Spread Is Very Wide Beyond a 3-to-6-month timeframe, the path of the dollar has depended on what other central banks are doing (Table I-1). The BoE, BoC, Norges Bank, and RBNZ all raised rates before the Fed. The Riksbank and RBA ended QE ahead of the Fed. The BoJ’s balance sheet has been flat-to-shrinking since 2021. The US dollar has tended to do well when US interest rates are in the top decile amongst the G10 countries (Chart I-9).  While that was true before the Covid-19 crisis, it is no longer the case today. This suggests the onus is on the Fed to meet market expectations and keep the dollar strong. Table I-1The Performance Of Currencies Is Mixed When Their Resident Central Bank Hikes Rates Lessons From Fed Interest Rate Hikes Lessons From Fed Interest Rate Hikes Chart I-9The Fed Is Lagging Other G10 Central Banks The Fed Is Lagging Other G10 Central Banks The Fed Is Lagging Other G10 Central Banks Interestingly, the yen has generally done very well around Fed rate hikes (Chart I-10), followed by commodity currencies (Table I-2). It also happens to be incredibly cheap today (Chart I-11). Our bias is that should inflation pick up faster in Japan, the yen will rally ahead of any anticipated changes to monetary policy. Chart I-10G10 Currencies Around The First Fed ##br##Rate Hike G10 Currencies Around The First Fed Rate Hike G10 Currencies Around The First Fed Rate Hike Table 2Most Currencies Appreciate Shortly After The First Fed Rate Hike Lessons From Fed Interest Rate Hikes Lessons From Fed Interest Rate Hikes Chart I-11The Yen Is Very Cheap The Yen Is Very Cheap The Yen Is Very Cheap Are Fed Rate Hikes Sustainable? There is a case to be made that the Federal Reserve could indeed hike interest rates faster than other economies. The 3-month rate-of-change in the dollar has closely followed the mini-growth oscillations between the US and other G10 economies (Chart I-12). US growth is now relatively strong (as measured by relative PMIs or relative economic surprise indices). Barring a global recession, the Fed has more scope to raise interest rates. Related Report  Foreign Exchange StrategyThe Yen In 2022 On the flip side, financial conditions in the US are tightening quickly as mortgage rates rise, and the dollar soars. This is happening at a time when growth is weak in China and the PBoC is on an easing path. Chinese long bond yields (a proxy for Chinese growth) tend to rise when the PBoC stimulates growth. (Chart I-13). When the number of Covid-19 cases in China rolls over, there will be a case for growth to firmly bottom. Chart I-12Economic Growth Is Relatively Strong In The US Economic Growth Is Relatively Strong In The US Economic Growth Is Relatively Strong In The US Chart I-13The Chinese Economy Is Soft The Chinese Economy Is Soft The Chinese Economy Is Soft This is important since most Asian economies are very dependent on China to close their output gaps and reach escape velocity in economic growth. Take the example of Japan. Tourist arrivals (mainly from Asia) generally represent 25% of the overall Japanese population but today, that number remains near zero. As a result, consumption outlays in Japan are well below the pre-pandemic trend (Chart I-14). As growth recovers, the Japanese economy should be one of the best candidates for generating non-inflationary growth. This is a bullish backdrop for the currency. Chart I-14Japanese Consumption Is Well Below Trend Japanese Consumption Is Well Below Trend Japanese Consumption Is Well Below Trend Finally, real interest rates in the US remain very low. Empirically, currencies react more to the path of relative real rates (Chart I-15). Chart I-15US Real Rates Are Very Low US Real Rates Are Very Low US Real Rates Are Very Low Seasonality: Friend Or Foe? Coincidentally, the dollar also usually weakens in the second half of the year (Chart I-16). This dovetails with our bias that the dollar also underperforms after the first Fed interest rate hike. This has been especially true over the last decade (Chart I-17). Chart I-16The Dollar Is Seasonally Weak In H2 Lessons From Fed Interest Rate Hikes Lessons From Fed Interest Rate Hikes Chart I-17The Dollar Is Seasonally Weak In H2 The Dollar Is Seasonally Weak In H2 The Dollar Is Seasonally Weak In H2 The dollar has already priced in that the Fed will lead the interest rate hiking cycle. However, as we have been highlighting in recent reports, rising inflation is a global problem and not one that is exclusive to the US. The hawks in the ECB are very uncomfortable with this week’s HICP (harmonized index of consumer prices) release of 9.8% in Spain, 7.3% in Germany, and 7% in Italy. As a comparison, headline inflation in the US is 7.9%. A weak euro will only fan the inflationary flame in the eurozone.  The Japanese economy could be next in unleashing inflationary surprises, especially on the back of a very cheap yen (Chart I-11). This will raise the probability that the Bank of Japan eases yield curve control. In short, the potential for upside surprises in interest rates is highest outside the US. Concluding Thoughts The academic evidence suggests that short-term interest rates matter more for currencies, especially when policy is close to the zero bound. The BIS report on the topic concludes that short maturity bonds have had the strongest FX impact.1 Moreover, near the effective lower bound, the foreign-exchange impact is greater as the adjustment burden falls onto the exchange rate. As FX becomes the axle of adjustment at lower interest rates, a strong dollar and weaker euro and yen are likely to grease the wheels of an economic rebound in these latter economies. For now, economic momentum in the US is stronger, which indicates that the Fed will initially deliver the bulk of rate hikes priced in the OIS curve this year. Beyond then, if growth picks up faster outside the US, especially in the euro area and Japan, then the USD could enter a consolidation phase. Finally, the yen has tended to be the best-performing currency after a Fed rate hike. Go short USD/JPY if it touches 124. Appendix: Currency Performance Around Interest Rate Hikes United States Lessons From Fed Interest Rate Hikes Lessons From Fed Interest Rate Hikes United States Lessons From Fed Interest Rate Hikes Lessons From Fed Interest Rate Hikes Euro Area Lessons From Fed Interest Rate Hikes Lessons From Fed Interest Rate Hikes Japan Lessons From Fed Interest Rate Hikes Lessons From Fed Interest Rate Hikes United Kingdom Lessons From Fed Interest Rate Hikes Lessons From Fed Interest Rate Hikes Canada Lessons From Fed Interest Rate Hikes Lessons From Fed Interest Rate Hikes   Australia Lessons From Fed Interest Rate Hikes Lessons From Fed Interest Rate Hikes New Zealand Lessons From Fed Interest Rate Hikes Lessons From Fed Interest Rate Hikes Switzerland Lessons From Fed Interest Rate Hikes Lessons From Fed Interest Rate Hikes Norway Lessons From Fed Interest Rate Hikes Lessons From Fed Interest Rate Hikes Sweden Lessons From Fed Interest Rate Hikes Lessons From Fed Interest Rate Hikes Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Ferrari, Massimo, Kearns, Jonathan and Schrimpf, Andreas, “Monetary policy’s rising FX impact in the era of ultra-low rates,” Bank of International Settlements, April 2017. Trades & Forecasts Strategic View Tactical Holdings (0-6 months) Limit Orders Forecast Summary

Executive Summary Petrocurrencies Have Lagged Terms Of Trade Petrocurrencies Have Lagged Terms Of Trade Petrocurrencies Have Lagged Terms Of Trade  Petrocurrencies have lagged the surge in crude prices. This has been specific to the currency space since energy stocks have been in an epic bull market.Both cyclical and structural factors explain this conundrum.Cyclically, rising interest rate expectations in the US have dwarfed the terms-of-trade boost that the CAD, NOK, MXN, COP and even BRL typically enjoy (Feature Chart).Structurally, the US is now the biggest oil producer in the world (and a net exporter of natural gas). This has permanently shifted the relationship between the foreign exchange of traditional oil producers and the US dollar.Oil prices are overbought and vulnerable tactically to any resolution in the Russo-Ukrainian conflict. That said, they are likely to remain well bid over a medium-term horizon, ultimately supporting petrocurrencies.Petrocurrencies also offer a significant valuation cushion and carry relative to the US dollar, making them attractive for longer-term investors.Tactically, the currencies of oil producers relative to consumers could mean revert. It also suggests the Japanese yen, which is under pressure from rising energy imports, could find some footing, even as oil prices remain volatile.RECOMMENDATIONINCEPTION LEVELINCEPTION DATERETURNShort NOK/SEK1.112022-03-24-Bottom Line: Given our thesis of lower oil prices in the near term, but firmer prices in the medium term, we will be selling a basket of oil producers relative to oil consumers, with the aim of reversing that trade from lower levels.FeatureOil price volatility is once again dominating global market action. After hitting a low of close to $96/barrel on March 16th, Brent crude is once again at $120 as we go to press. Over the last two years, Brent crude has been as cheap as $16, and as expensive as $140. Energy stocks (and their respective bourses) have been the proximate winner from rising oil prices (Chart 1).Related ReportForeign Exchange StrategyWhat Next For The RMB?In foreign exchange markets, the currencies of commodity-producing countries have surprisingly lagged the improvement in oil prices (Chart 2). Historically, higher oil prices have had a profound impact on the external balance of oil producing versus consuming countries in general and petrocurrencies in particular. Chart 1Energy Stocks Have Tracked Forward Oil Prices Energy Stocks Have Tracked Forward Oil Prices Energy Stocks Have Tracked Forward Oil Prices   Chart 2Petrocurrencies Have Lagged Oil Prices Petrocurrencies Have Lagged Oil Prices Petrocurrencies Have Lagged Oil Prices  Based on the observation above, this report addresses three key questions:Are there cyclical factors depressing the performance of petrocurrencies?Are there structural factors that have changed the relationship of these currencies with the US dollar?What is the outlook for oil, and the impact on short term versus longer-term currency strategy?We will begin our discussion with the outlook for oil.Russia, Oil, And PetrocurrenciesA high-level forecast from our Commodity & Energy Strategy colleagues calls for oil prices to average $93 per barrel this year and next.1 The deduction from this forecast is that we could see spot prices head lower from current levels this year but remain firm in 2023. From our perspective, there are a few factors that support this view:Forward prices tend to move in tandem with the spot fixing (Chart 3), but recently have also been a fair predictor of where current prices will settle over the medium term. Forward oil prices are trading at a significant discount to spot, suggesting some measure of mean reversion (Chart 4). Chart 3Forward And Spot Oil Prices Move Together Forward And Spot Oil Prices Move Together Forward And Spot Oil Prices Move Together   Chart 4The Oil Curve And Spot Prices The Oil Curve And Spot Prices The Oil Curve And Spot Prices  There is a significant geopolitical risk premium embedded in oil prices. According to the New York Federal Reserve model, the demand/supply balance would have caused oil prices to fall between February 11 and February 25 this year. They however rose. This geopolitical risk premium has surely increased since then (Chart 5).Chart 5Oil Prices Embed A Significant Geopolitical Risk Premium The Oil-Petrocurrency Conundrum The Oil-Petrocurrency Conundrum  Russian crude is trading at a sizeable discount compared to other benchmarks. This means that the incentive for substitution has risen significantly. Our Chief Commodity expert, Robert Ryan, noted on BLU today that intake from India is rising. This is helping put a floor on the Russian URAL/Brent discount blend at around $30 (Chart 6). Oil is fungible, and seaborne crude can be rerouted from unwilling buyers to satiate demand in starved markets.A fortnight ago, we noted how the US sanctions on Russia could shift the foreign exchange landscape, especially vis-à-vis the RMB. Specifically, RMB-denominated trade in oil is likely to increase significantly going forward. China has massively increased the number of bilateral swap lines it has with foreign countries, while stabilizing the RMB versus the US dollar.2Finally, smaller open economies such as Canada, Norway and even Mexico are opening the oil spigots (Chart 7). While individually these countries cannot fill any potential gap in Russian production, collectively they could help in the redistribution of oil supplies. Chart 6Russian Oil Is Selling At A Discount Russian Oil Is Selling At A Discount Russian Oil Is Selling At A Discount   Chart 7Small Oil Producers Will Benefit From High Prices Small Oil Producers Will Benefit From High Prices Small Oil Producers Will Benefit From High Prices  The observations above suggest that the currencies of small oil-producing nations are likely to benefit in the medium term from a redistribution in oil demand. Remarkably, there has been little demand destruction yet from the rise in prices, according to the New York Fed. This suggests that as the global economy reopens, and the demand/supply balance tightens, longer-term oil prices will remain well bid.The key risk in the short term is the geopolitical risk premium embedded in oil prices fades, especially given the potential that Europe, China, and India continue to buy Russian supplies. We have been playing this very volatile theme via a short NOK/SEK position. We are stopped out this week for a modest profit and are reinitiating the trade if NOK/SEK hits 1.11.On The Underperformance Of Petrocurrencies? Chart 8Petrocurrencies Have Lagged Terms Of Trade Petrocurrencies Have Lagged Terms Of Trade Petrocurrencies Have Lagged Terms Of Trade  The more important question is why the currencies of oil producers like the CAD, NOK, MXN or even BRL have not kept pace with oil prices as they historically have. As our feature chart shows (Chart 8), petrocurrencies have severely lagged the improvement in their terms of trade. This has been driven by both cyclical and structural factors.Cyclically, the underlying driver of FX in recent quarters has been the nominal interest rate spread between the US and its G10 counterparts. We have written at length on this topic, and on why we think there is a big mispricing in market behavior in our report – “The Biggest Macro Question By FX Investors Could Potentially Be The Least Relevant.” In a nutshell, two-year yields in the G10 have been lagging US rates, despite other central banks being ahead of the curve in hiking interest rates. This means that rising interest rate expectations in the US have dwarfed the terms of trade boost that the CAD, NOK, MXN, COP and even BRL typically enjoy.Structurally, the US is now the biggest oil producer in the world (Chart 9). This means the CAD/USD and NOK/USD exchange rates are experiencing a tectonic shift on a terms-of-trade basis. In 2010, the US accounted for only about 6% of global crude output. Collectively, Canada, Norway, and Mexico shared about 10% of global oil production. The elephant in the room was OPEC, with a market share just north of 40%. Today, the US produces over 14%, with Russia and Saudi Arabia around 13% each, the US having grabbed market share from many other countries. Chart 9The US Dominates Oil Production The US Dominates Oil Production The US Dominates Oil Production   Chart 10The US Dollar Is Becoming Increasingly Correlated To Oil The US Dollar Is Becoming Increasingly Correlated To Oil The US Dollar Is Becoming Increasingly Correlated To Oil  As a result of this shift, the positive correlation between petrocurrencies and oil has gradually eroded. Measured statistically, the dollar had a near-perfect negative correlation with oil around the time US production was about to take off. Since then, that correlation has risen from around -0.9 to around -0.2 (Chart 10).A Few Trade IdeasThe analysis above suggests a few trade ideas are likely to generate alpha over the medium term:Long Oil Producers Versus Oil Consumers: This trade will suffer in the near term as oil prices correct but benefit from a relatively tighter market over a longer horizon. It will also benefit from the positive carry that many oil producers provide (Chart 11). We will go long a currency basket of the CAD, NOK, MXN, BRL, and COP versus the euro at 5% below current levels.Chart 11Real Rates Are High Amongst Petrocurrencies The Oil-Petrocurrency Conundrum The Oil-Petrocurrency Conundrum  Sell CAD/NOK As A Trade: Norway is at the epicenter of the likely redistribution that will occur with a Russian blockade of crude, while Canada is further away from it. Terms of trade in Norway are doing much better than a relative measure in Canada (Chart 12). The discount between Western Canadian Select crude oil and Brent has also widened, which has historically heralded a lower CAD/NOK exchange rate. Chart 12CAD/NOK And Terms Of Trade CAD/NOK And Terms Of Trade CAD/NOK And Terms Of Trade  Follow The Money: Oil now trades above the cash costs for many oil-producing countries. This means the incentive to boost production, especially when demand recovers, is quite high. This incentivizes players with strong balance sheets to keep the taps open. This could be a particular longer-term boon for the Canadian dollar which is seeing massive portfolio inflows (Chart 13). Chart 13Canadian Oil Export Boom And Portfolio Flows Canadian Oil Export Boom And Portfolio Flows Canadian Oil Export Boom And Portfolio Flows  On The Yen (And Euro): Rising oil prices have been a death knell for the yen which is trading in lockstep with spot prices. Ditto for the euro. However, the yen benefits from very cheap valuations and extremely depressed sentiment. Any temporary reversal in oil prices will boost the yen (Chart 14). In our trading book, we were stopped out of a short CHF/JPY position last Friday, and we will look to reinitiate this trade in the coming days.  Chart 14The Yen And Oil Prices The Yen And Oil Prices The Yen And Oil Prices   Chester NtoniforForeign Exchange Strategistchestern@bcaresearch.comFootnotes1 Please see Commodity & Energy Strategy Weekly Report, “Uncertainty Tightens Oil Supply”, dated March 17, 2022.2 Please see Foreign Exchange Strategy Special Report, “What Next For The RMB?”, dated March 11, 2022.Trades & ForecastsStrategic ViewTactical Holdings (0-6 months)Limit OrdersForecast Summary

Dear client, In addition to this weekly report, we sent you a Special Report from our Geopolitical Strategy service, highlighting the risk from the Russo-Ukrainian conflict. Kind regards, Chester Executive Summary The Ukraine crisis will lead to a period of strength for the DXY. Countries requiring foreign capital will be most at risk from an escalation in tensions. Portfolio flows have reaccelerated into the US, on the back of a rise in Treasury yields. This will be sustained in the near term. The euro area on the other hand has already witnessed significant portfolio outflows, on the back of Russo-Ukrainian tensions and an energy crisis. Countries with balance of payment surpluses like Switzerland and Australia are good havens amidst the carnage. Oil-producing countries such as Norway and Canada have also seen an improvement in their balance of payments, on the back of a strong terms-of-trade tailwind. This will be sustained in the near term. Balance Of Payments Across The G10 The Ukraine Crisis And Balance Of Payments The Ukraine Crisis And Balance Of Payments Bottom Line: The dollar is king in a risk-off environment. That said, the US and the UK sport the worst balance of payments backdrops, while Norway, Switzerland, and Sweden have the best. This underpins our long-term preference for Scandinavian currencies in an FX portfolio. In the near term, we think the DXY will peak near 98-100, but volatility will swamp fundamental biases. Feature Chart 1The US Runs A Sizeable Deficit The Ukraine Crisis And Balance Of Payments The Ukraine Crisis And Balance Of Payments The Russia-Ukraine conflict continues to dictate near-term FX movements. With Russia’s invasion of Ukraine, the risk of escalation and/or a miscalculation has risen. FX volatility is increasing sharply, and with it, the risk of a further selloff in currencies dependent on foreign capital inflows. As a reserve currency, the dollar has also been strong. It is difficult to ascertain how this imbroglio will end. However, in this week’s report, we look at which currencies are most vulnerable (and likely to stay vulnerable) from a balance of payments standpoint. Chart 1 plots the basic balance – the sum of the current account balance and foreign investment – across G10 countries. It shows that at first blush, Norway, Switzerland, Sweden, and Australia are the most resilient from a funding standpoint, while New Zealand, the UK, and the US are the most vulnerable. In Chart 2, we rank G10 currencies on eight different criteria: The basic balance, which we highlighted above. Real interest rate differentials, using the 10-year tenor and headline inflation. Relative growth fundamentals, as measured by the Markit manufacturing PMI. Three fair value models which we use in-house. The first is our Purchasing Power Parity model, which adjusts consumption basket weights across the G10 to reflect a more apples-to-apples comparison. The second is our long-term fair value model (LTFV), which adjusts for productivity differentials between countries; and the final is our intermediate-term timing model (ITTM), which separates procyclical from safe-haven currencies by including a risk factor such as corporate spreads. All three models are equally weighted in our rankings. The net international investment position (NIIP), which highlights currencies that are most likely to witness either repatriation flows or a positive income balance in the current account. Finally, net speculative positioning, which tells us which currencies have crowded long positions, and which ones sport a consensus sell. Chart 2The Scandinavian Currencies Are Attractive The Ukraine Crisis And Balance Of Payments The Ukraine Crisis And Balance Of Payments The conclusions from this chart are similar to our basic balance scenario – NOK, SEK, AUD, CHF, and JPY stand out as winners while GBP, NZD, and USD are the least attractive. The US dollar is a special case given its reserve currency status, with a persistent balance of payments deficit. The rise in the greenback amidst market volatility is a case in point. However, portfolio flows into the dollar also tend to be cyclical, so a resolution in the Ukraine/Russia conflict will put a cap on inflows. Equity portfolio flows had dominated financing of the US current account deficit but are relapsing (Chart 3). Bond portfolio flows have rebounded on the back of rising US yields, but US TIPS yields remain very low by historical standards (Chart 4). If they do not improve much further, specifically relative to other developed markets, it will be tough to justify further inflows into US Treasurys. Chart 3Equity Portfolio Flows Into The US Are Relapsing Equity Portfolio Flows Into The US Are Relapsing Equity Portfolio Flows Into The US Are Relapsing Chart 4Bond Portfolio Flows Into The US Are Strong Bond Portfolio Flows Into The US Are Strong Bond Portfolio Flows Into The US Are Strong In this week’s report, we look at the key drivers of balance of payments dynamics across the G10, starting with the US, especially amidst a scenario where the forfeit of foreign capital could come to the fore. United States Chart 5US Balance Of Payments US Balance Of Payments US Balance Of Payments The US trade deficit continues to hit record lows at -$80.7 billion for the month of December. Over the last few years, it has become increasingly difficult to fund this widening trade deficit via foreign purchases of US Treasurys. A positive net income balance has allowed a slower deterioration in the US current account balance, though at -$214.8 billion for Q3, it remains close to record lows. The overall picture for both the trade and current account balance is more benign as a share of GDP, given robust GDP growth (Chart 5). That said, as a share of GDP, the trade balance stands at -3.5%, the worst in over a decade. Foreign direct investment into the US has been improving of late. This probably reflects an onshoring of manufacturing, triggered by the Covid-19 crisis. That said, despite this improvement, the US still sports a negative net FDI backdrop. In a nutshell, the basic balance in the US (the sum of the current account and foreign direct investment) is still deteriorating. The dollar tends to decline on a multi-year basis when the basic balance peaks and starts worsening.       Euro Area Chart 6Euro Area Balance Of Payments Euro Area Balance Of Payments Euro Area Balance Of Payments The trade balance in the euro area has significantly deteriorated in recent quarters, on the back of an escalating energy crisis. Russia’s invasion of Ukraine marks the cherry on top. On a rolling 12-month basis, the trade surplus has fallen to 1% of GDP (Chart 6). This is particularly telling since for the month of December, the trade balance came in at €-4.6 billion, the worst since the euro area debt crisis. The current account continues to post a surplus of 2.6% of GDP, on the back of a positive income balance. However, FDI inflows are relapsing. After about two decades of underinvestment in the euro area, FDI inflows were at their highest level, to the tune of about 2% of GDP in 2021. Those have now completely reversed on the back of uncertainty. The combination of an energy crisis and dwindling FDI is crushing the euro area’s basic balance surplus. A rising basic balance surplus has been one of the key pillars underpinning a bullish euro thesis. Should the deterioration continue, it will undermine our longer-term bullish stance on the euro. It is encouraging that portfolio investments have turned less negative in recent quarters, as bond yields in the euro area are rising. Should this continue, it will be a good offset to the deterioration in FDI.   Japan Chart 7Japan Balance Of Payments Japan Balance Of Payments Japan Balance Of Payments Like the euro area, the trade balance in Japan continues to be severely hampered by rising energy imports. The trade deficit in January deteriorated to a near record of ¥2.2 trillion, even though export growth remained very robust. Income receipts from Japan’s large investment positions abroad continue to buffer the current account, but a resolution to the energy crisis will be necessary to stem Japan’s basic balance from deteriorating (Chart 7). The process of offshoring has sharply reversed since the Covid-19 crisis. While FDI is still deteriorating, it now stands at -2.4% of GDP, compared to -4.3% just before the pandemic. Net portfolio investments are also accelerating, especially given the rise in long-term interest rates in Japan, positive real rates, and the value bias of Japanese equities. We are buyers of the yen over the long term, but a further rise in global yields and energy prices are key risks to our view.             United Kingdom Chart 8UK Balance Of Payments UK Balance Of Payments UK Balance Of Payments The UK has the worst trade balance in the G10, and the picture has not improved much since the pandemic (currently at -6.7% of GDP). Similar to both the euro area and Japan, much of the drag on the trade balance has been due to rising import costs from energy and fuels. This puts the UK at risk of an escalation in the conflict between Ukraine and Russia. Meanwhile, the improvement in the income balance over the last few years has started to deteriorate, as transfer payments under the Brexit withdrawal agreement kick in. As a result, the current account balance is deteriorating anew (Chart 8). Both portfolio and direct investment in the UK were robust in the post-Brexit environment but have started to deteriorate. This is critical since significant foreign investment is necessary to boost productivity in the UK and prevent the pound from adjusting much lower. With bond yields in the UK rising, and the FTSE heavy in cyclical stocks, this should limit further deterioration in the UK’s financial account. A significant drop in the estimated path of settlement payments for Brexit will also boost the income balance. The key for the pound over the coming years remains how fast the UK can improve productivity, which will convince foreign investors that the return on capital for UK assets will increase. Canada Chart 9Canada Balance Of Payments Canada Balance Of Payments Canada Balance Of Payments Canada’s domestic economy has been relatively insulated from the geopolitical shock in Europe, but its export sector is benefiting tremendously from it. Rising oil prices are boosting Canadian terms of trade. As a result, the current account has turned into a surplus for the first time since 2009, in part driven by an improving trade balance (Chart 9). Outside of trade, part of the improvement in the Canadian current account balance is specifically driven by income receipts from Canada’s positive net international investment position. At C$1.5 trillion, income receipts are becoming an important component of the current account balance. Foreign direct investment into Canada continues to remain robust, given strong commodity prices. This is boosting our basic balance measure, which today sits at a surplus of 2.4% of GDP and should continue to improve. Finally, because of Canada’s improving balance-of-payments backdrop, it is no longer reliant on foreign capital as it had been in the past, which supports the loonie.         Australia Chart 10Australia Balance Of Payments Australia Balance Of Payments Australia Balance Of Payments Australia continues to sport the best improvement in both its trade and current account balances over the last few years. As a result, the basic balance has eclipsed 4% of GDP for the first time since we have been measuring this series (Chart 10). The story for Australia remains improving terms of trade, specifically in the most desirable commodities – copper, high-grade iron ore, liquefied natural gas, and to a certain extent, high-grade coal. Foreign direct investment in Australia has eased significantly. Investment in projects in the resource space are now bearing fruit, easing the external funding constraint. Meanwhile, domestic savings can now be easily recycled for sustaining capital investment. In fact, foreign direct investment turned negative in Q4 2021. This also explains the drop in net portfolio investment since Australians now need to build a positive net international investment position. We have a limit buy on the Aussie dollar at 70 cents, as we are bullish the currency over a medium-term horizon.         New Zealand Chart 11New Zealand Balance Of Payments New Zealand Balance Of Payments New Zealand Balance Of Payments For the third quarter of 2021, New Zealand’s current account balance hit record lows, despite robust commodity (agricultural) prices. Imports of fertilizers, crude oil, and vaccines have led to a widening trade deficit. A drop in the exports of wood also affected the balance. With a negative net international investment position of about 48% of GDP, the income balance also subtracted from the current account total (Chart 11). From a bigger-picture perspective, New Zealand’s basic balance has been negative for many years, as coupon and dividend payments to foreign investors, as well as valuation adjustments from net foreign liabilities, have kept the current account in structural deficit. However, as the prices of key agricultural goods head higher, New Zealand can begin to benefit from a terms-of-trade boom that will limit its external funding requirement. In that respect, portfolio investments are also improving. New Zealand has the highest bond yield in the G10, on the back of the highest policy rate so far (the RBNZ raised interest rates again this week). New Zealand’s defensive equity market has also corrected sharply amidst the general market riot. As such, foreign investors could begin to favor this market again based on high yields and a reset in valuations. Going forward, New Zealand should continue to see further improvement in its basic balance relative to the US, supporting the kiwi. Switzerland Chart 12Switzerland Balance Of Payments Switzerland Balance Of Payments Switzerland Balance Of Payments The Swiss trade balance remains in a structural surplus, with a post Covid-19 boom that has led a new high as a share of   GDP (Chart 12). Global trade has been rather resilient due to high demand for goods. While Switzerland has a large net international investment position, income flows this quarter were hampered by servicing costs for foreign direct investments. The net international investment position did improve by CHF27 billion on a quarter-over-quarter basis in Q3, on the back of a net increase in foreign asset purchases. Currency movements also had little impact on the portfolio in Q3, which is atypical. The SNB will always have to contend with a structural trade surplus that puts upward pressure on the currency. This will keep the Swiss franc well bid, especially in times of crisis when the positive balance-of-payments backdrop makes the CHF a safe haven.             Norway Chart 13Norway Balance Of Payments Norway Balance Of Payments Norway Balance Of Payments Q3 2021 saw a strong recovery in Norway’s trade account that is likely to carry over to this year. A recovery in crude oil and natural gas prices was a welcome boon. The lack of tourism also boosted the services account (Norwegians travel and spend less abroad than foreigners visiting Norway). The ongoing electricity crisis in Europe was also an opportune export channel for Norway, which for the first time, opened its 450-mile-long, 1400-megawatt North Sea cable link to the UK. Positive income flows also benefit the current account and the krone (Chart 13). With one of the largest NIIPs in the world heavily skewed towards equity dividends, the NOK benefits when yields rise, even though the domestic fixed-income market is highly illiquid. While a resolution of the Russian-Ukrainian crisis could sap the geopolitical risk premium from oil, the reopening of the global economy will benefit Norwegian exports of oil and gas. Tepid investment in global oil and gas exploration will also ensure Norway’s terms of trade remain robust.       Sweden Chart 14Sweden Balance Of Payments Sweden Balance Of Payments Sweden Balance Of Payments The Swedish current account balance has deteriorated slightly in the last few quarters, on the back of supply-side bottlenecks. Particularly, exports of cars have been hampered amidst a semiconductor shortage. That said, the primary income surplus remains a key pillar of the current account, keeping the basic balance at a healthy surplus of about 6% of GDP (Chart 14). Portfolio inflows into Sweden have dwindled, like most other European economies. If this has been due to geopolitical tensions in Europe, it will eventually prove to be fleeting. That said, the Riksbank remains one of the most dovish in the G10 and the OMX is also one of the most cyclical stock markets, which may have spooked short-term foreign investments. The Swedish krona has been the weakest G10 currency year-to-date. Given that we expect most of the headwinds to be temporary, and the basic balance backdrop remains solid, we will go long SEK versus both the euro and the US dollar.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary

Executive Summary The Euro And Relative Growth The Euro And Relative Growth The Euro And Relative Growth The euro is likely to appreciate over the course of 2022. But the path will be volatile, with a retest of recent EUR/USD lows within the central band of possible outcomes. Our 2022 target for the euro is 1.20. This partly hinges on cheap valuations. Beyond 2022, a bold estimate could see the euro gravitate towards 1.40. The pricing of interest rate hikes by the ECB this year are too aggressive. But this is also the case for the Federal Reserve, especially if inflation proves transitory. Our bias is that appreciation in the euro will be more driven by improving relative economic fundamentals as the 2022 cycle unfolds. A bottom in Chinese growth could be the ultimate arbiter of which mega economy outperforms. Sentiment on the euro is only neutral. This suggests that an escalation in Russo-Ukrainian tensions, as well as a more dovish ECB, are key risks in the short term. A short EUR/JPY position is a good hedge for this risk. In our FX portfolio, we are long EUR/CHF and long EUR/GBP as equally playable themes. We would buy the EUR/USD at current levels but suspect a better entry point awaits us. Recommendations Inception Level Inception Date Return Long EUR/CHF 1.05 2021-11-19 0.62% Long EUR/GBP 0.846 2021-10-15 -.71%   Bottom Line: A positive surprise in Chinese growth, which will boost the euro area trade balance, will be a catalyst for eurozone growth. So will a decline in Russo-Ukrainian tensions and lower energy inflation. Feature The most persistent question we have received in recent weeks is the outlook for the euro. As the premier anti-dollar asset, most clients have been surprised by recent strength in the European currency, betting that a hawkish Fed and US exceptionalism will push the greenback to new highs. A domestic energy crisis interlinked with a brewing war in their backyard has created perfect conditions for selling the euro. With US inflation surprising to the upside, the case for maintaining a dollar-bullish stance remains in place. Yet, the dollar is well below its previous highs. Our suspicion is that the market faces a conundrum. Transitory inflation will nudge the Fed to underwhelm market expectations of aggressive rate hikes. Meanwhile, sticky inflation means that other central banks will eventually catch up to the Federal Reserve in tightening monetary policy. This tug of war has been a defining theme of our strategy for currencies in 2022.1 Specific to the euro area, there is a lot of bad economic news that is now well priced in, while good news is underappreciated by markets. This is becoming evident in the interest rate market, where real Bund yields are creeping noticeably higher. The spread of Omicron in the euro area is receding in lockstep with the deceleration in the US (Chart 1). As a result, the potential growth profile of the euro area is improving tremendously (Chart 2). Should this prove durable, it will put a solid floor under the euro. Chart 1The Pandemic Is Receding The Pandemic Is Receding The Pandemic Is Receding Chart 2The Euro And Relative Growth The Euro And Relative Growth The Euro And Relative Growth The Case For European Growth Growth is moderating around the world. That said, the German manufacturing PMI has been sharply outpacing that of the US. What is also true is that most measures of euro area growth that we monitor are rising fast relative to the US. The results are preliminary, but the possibility of a growth rotation from the US to other economies, including the eurozone, is very much underappreciated by markets. The economic surprise index in the euro area is strong relative to the US, pointing to a stronger euro (Chart 3). Bloomberg economic forecasts suggest that euro area growth will outpace growth in the US this year. According to the consensus, the euro area will grow by 4.2% in 2022, compared to the US at 3.9%. Remarkably, eurozone growth has typically lagged growth in the US by a significant margin. If past is prologue, it suggests the euro is not priced for this paradigm change (Chart 4). Chart 3Economic Surprises And ##br##The Euro Economic Surprises And The Euro Economic Surprises And The Euro Chart 4Bloomberg Forecasters Expect A Pickup In Eurozone Growth Bloomberg Forecasters Expect A Pickup In Eurozone Growth Bloomberg Forecasters Expect A Pickup In Eurozone Growth Other economic forecasts corroborate this view. The IMF expects eurozone growth to moderate from 5.2%, to 3.9% in 2022. This is an advantage over the US, where growth is expected to moderate from 5.6% in 2021, to 4% in 2022. The Atlanta Fed GDP growth tracker suggests US growth will slow to a crawl in Q1. The ZEW survey points to a meaningful rebound in the German (and euro area) PMI in the coming months (Chart 5). This will further widen the gap between European and US growth. The key denominator for all these forecasts is a bottoming in Chinese growth. The euro area needs the manufacturing and external sector to keep humming, with China as a critical import partner. Industrial production in the euro area, relative to the US, tends to track the Chinese credit impulse closely (Chart 6). Our bias is that the Chinese credit impulse has bottomed. This will be a catalyst for more Chinese demand for European goods. Chart 5The ZEW Survey Points To An Improving German PMI The ZEW Survey Points To An Improving German PMI The ZEW Survey Points To An Improving German PMI Chart 6Europe Is Partly Dependent On China Europe Is Partly Dependent On China Europe Is Partly Dependent On China The ECB And Interest Rates Chart 7The Gap Between Expected US-EUR Interest Rates Is Wide The Gap Between Expected US-EUR Interest Rates Is Wide The Gap Between Expected US-EUR Interest Rates Is Wide The markets have begun to reprice higher interest rates in the eurozone. Admittedly, this has been partly due to higher expected inflation. In our view, the repricing by markets is warranted due to the gaping wedge between US versus European interest rate expectations. According to December 2022 contracts, markets expect the Fed to hike interest rates by significantly more than the ECB (Chart 7). It is true that structurally, inflation in the eurozone has been lower than in the US. In fact, our European Investment Strategy colleagues highlight that by stripping out energy, and the impact of VAT tax increases, European inflation is even lower. When CPI baskets are adjusted item for item, eurozone inflation today is indeed lower compared to the US, but not by much (Chart 8). For example, energy and transportation are only 14% of the eurozone CPI basket versus 26% in the US (Table 1). Meanwhile, the ECB targets HICP inflation (not core) that sits at 5.1%, versus a target of 2%.  Chart 8Item-For-Item Inflation: US Versus Eurozone Item-For-Item Inflation: US Versus Eurozone Item-For-Item Inflation: US Versus Eurozone Table 1Differences In The US And Eurozone CPI Basket The Unsung Case For The Euro The Unsung Case For The Euro In the coming months, inflation is likely to subside in the eurozone, but probably by less than markets expect. The key driver of inflation expectations in the eurozone (and in the US) are long-dated commodity prices (Chart 9). This has become even more evident, given the surge in electricity prices across many European countries. Robert Ryan, our Chief Commodity Strategist, expects long-dated crude prices to be revised upward, as the oil curve remains persistently backwardated. This puts a floor on how low inflation expectations can relapse in the euro area and will keep the ECB on edge. Meanwhile, the employment picture in the eurozone is also improving. Adjusting for the higher rate of structural unemployment, euro area joblessness compares favorably with the US (Chart 10). It is true that wage growth remains anemic, but it is also the case that the behavior of wages can exhibit a structural shift at very low levels of employment.  Chart 9What Drives Eurozone Inflation Expectations? What Drives Eurozone Inflation Expectations? What Drives Eurozone Inflation Expectations? Chart 10US Versus Eurozone Labor Markets US Versus Eurozone Labor Markets US Versus Eurozone Labor Markets Finally, the euro zone has a lot of pent-up demand. This could help bolster growth in the coming quarters and even beyond. While not a subject of this report, we suspect that the cascading crises in the eurozone could have sown the seeds for a productivity boom in the coming years. For a 12-18-month outlook, high savings and easy fiscal policy will allow European growth to recover in the coming quarters. EUR/USD Valuation And Future Returns Making a structural case for the euro is easy when it comes to valuation. According to our in-house PPP models, an investor who buys the euro today can expect to make 4%-5% a year over the next decade, should the euro stay at current levels of undervaluation versus the US. This will occur if Eurozone inflation keeps lagging that in the US.  (Chart 11). That said, this is the Goldilocks case. A simple return to PPP fair value will suggest the euro will rise by a robust 20%. For 2022, our forecast for the euro is more in the 1.20-1.23 range, 8% above current levels. Our stance is measured because investors are only neutral the euro (Chart 12). Usually, this means that the macroeconomic environment becomes the dominant driver, rather than sentiment. With a Russo-Ukrainian crisis still in the backyard and the potential for more market volatility, an undershoot in the euro cannot be ruled out.  Chart 11The Goldilocks Case For The Euro The Goldilocks Case For The Euro The Goldilocks Case For The Euro Chart 12Sentiment On The Euro Is Only Neutral Sentiment On The Euro Is Only Neutral Sentiment On The Euro Is Only Neutral That said, interest rate differentials are now moving in favor of the euro. Italian BTPs now yield 1.9%, like US Treasurys. The US Treasury-Bund spread has also narrowed. This removes a lot of the incentive for Europeans to flood the US Treasury or TIPs market, should market volatility subside. Given this confluence of factors, we have chosen to play euro strength via two channels: Long EUR/CHF: This trade will benefit from positive interest rate differentials. Also, the Swiss franc has been bid up relative to the euro on safe-haven demand. This has outpaced the traditional demand for safety, using the DXY index as a proxy (Chart 13). Long EUR/GBP: This is a bet on improving economic fundamentals between the eurozone and the UK (Chart 14), as well as a bet on policy convergence between the two economies. Chart 13Stay Long EUR/CHF Stay Long EUR/CHF Stay Long EUR/CHF Chart 14Stay Long EUR/GBP Stay Long EUR/GBP Stay Long EUR/GBP   Footnotes 1 Please see Foreign Exchange Strategy Report, “The Biggest Macro Question By FX Investors Could Potentially Be The Least Relevant”, dated January 14, 2022.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Tactical Holdings (0-6 months) Limit Orders Forecast Summary