Canada

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

OPEC 2.0’s meeting next week in Vienna once again will feature a full cast of dignitaries representing member states, including the energy ministers from the Kingdom of Saudi Arabia (KSA) and Russia, Khalid al-Falih and Alexander Novak. They have led the coalition since it was formed two years ago to halt a destructive oil-price collapse occasioned by the disastrous OPEC market-share war, which was launched at a similar gathering in November 2014. U.S. President Donald Trump will be present in Vienna, if only in spirit; and via Twitter, of course, continuing to press the oil exporters to maintain production at record high levels. We expect Trump’s demands to go unheeded. The leaders of OPEC 2.0 – and their bosses – likely will agree to production cuts in Buenos Aries at the G20 meeting starting tomorrow, which energy ministers will ratify in Vienna. If they don’t, the 30.2% decline in Brent since early October will mark a stopping-off point in a larger down move (Chart 1). Chart 1Another Price Collapse Looms, Without An OPEC 2.0 Production Cut Another Price Collapse Looms, Without An OPEC 2.0 Production Cut Another Price Collapse Looms, Without An OPEC 2.0 Production Cut Our 2019 Brent forecast remains at $82/bbl, with WTI $6/bbl lower. We expect OPEC 2.0 will agree to cut 1.0 – 1.4mm b/d of production, to undo the supply shock delivered via waivers on the U.S. export sanctions against Iran.1 Without production cuts our forecast will be lowered. Highlights Energy: Overweight. Canadian crude oil prices likely will remain depressed, as takeaway pipeline capacity remains fully booked and producers are forced to use expensive rail transport to move their barrels south (see below). The WCS – WTI differential recently traded close to -$50/bbl, due to pipeline constraints. Base Metals: Neutral. Zinc’s near-record physical-to-prompt futures backwardation remains close to recent highs, on the back of sharply lower stocks at the LME and SHFE. 2 Precious Metals: Neutral. Gold remains in the middle of the range it’s occupied since 2013, on either side of $1,225/oz going into the G20 meeting. Ags/Softs: Underweight. Soybeans recovered slightly ahead of the G20 meeting in Buenos Aries tomorrow. Markets will be watching for any sign of a thaw in the Sino – U.S. trade war. Feature Two years into the oil-price recovery, OPEC 2.0 member states continue to suffer from post-traumatic budget disorders (PTBD). The coalition’s leaders need higher prices, as do the rest of its members. KSA, Russia and the other OPEC 2.0 member states are coming off weak recoveries from the oil-price collapse of 2015 – 16. The oil price required to balance KSA’s budgetary obligations – its fiscal breakeven (FBE) price – averages $82.90/bbl this year and next, according to the IMF’s most recent estimates.3 If prices remain lower for longer, KSA’s official reserves will continue to fall, as its sovereign wealth fund continues to be tapped to fill budget gaps. The Kingdom’s official reserves, which stand at ~ $495 billion by the IMF’s reckoning, have fallen by almost one-third versus their 2014 peak, as a result of the lingering effects of the oil-price collapse.4 The Kingdom needs higher prices to transition to a less oil-dependent economy, and to meet its budget obligations in the present. Lastly, if it ever hopes to IPO its state oil company, Aramco, to fund its diversification efforts, KSA will have to have higher prices. The Middle East oil exporters as a group (ex Libya and Yemen, which are failed states), also are especially vulnerable to another oil-price collapse. The IMF estimates that every $10/bbl reduction in oil prices translates into 3 percentage-point drop in these states’ GDPs, and spawns untoward economic ramifications – e.g., tightening financial conditions leading to asset-price corrections, deterioration of banks’ assets, and slower growth. 5 As for Russia, it only started recovering last year from the oil-price shock of 2015 – 16 and the imposition of Western sanctions following its annexation of Crimea. Prior to that, real wages fell precipitously, and the government was required to tighten fiscal and monetary policy to control inflation following the collapse of the rouble, when the central bank stopped defending it in the wake of falling oil prices. Real GDP fell 2.5% in 2015 and 0.2% in 2016, then grew at a 1.5% rate last year, which was below expectations, according to the IMF. Growth is expected to come in at 1.7% this year, although the recent collapse in oil prices and renewed tensions with Ukraine could temper this outlook.6 The IMF warned in its July 2018 assessment of the economy, that “structural constraints” – high levels of state control, economic concentration and regulation, weak institutions and infrastructure – and geopolitical tensions “raised uncertainty and dampened domestic and foreign private investment.” Against this backdrop, President Trump’s insistence upon keeping KSA’s and OPEC’s production higher to keep U.S. gasoline prices lower puts his “oil policy” directly in opposition to the interests of KSA and its Gulf allies. Even though Russia has geared its budget to withstand oil prices as low as $40/bbl, lower prices will impact it, albeit to a lesser extent than the Middle East OPEC states. These states are not alone in being disadvantaged by President Trump’s insistence on lower-for-longer oil prices. U.S. shale-oil producers, which are driving the country’s oil output surge, do not benefit from lower prices. WTI prices in the low-$50s – and West Texas Midland prices trading ~ $6/bbl below that, because of pipeline constraints in the Permian Basis – will reduce capex in the shales and imperil growth (Chart 2). Chart 2Bottlenecks Pressure Spreads Bottlenecks Pressure Spreads Bottlenecks Pressure Spreads In addition, the U.S. defense contractors, whose interest President Trump recently cited as his principal foreign policy driver when he was demanding higher OPEC production, know that without stronger oil prices, KSA will not be able to follow through on the $110+ billion of arms deals contained in various letters of intent signed last year during the president’s visit to the Kingdom.7 Net, we expect OPEC 2.0 to agree on production cuts of between 1.0mm and 1.4mm b/d at its December 6 meeting. In our balances modeling, to be conservative, we assume OPEC 2.0 (ex Libya, Nigeria and Venezuela) production next year will be 900k b/d below the peak reached this month (Chart 3). This, along with steady demand – we assume growth of 1.46mm b/d next year, which takes global demand over 101.6mm b/d next year – drives our $82/bbl forecast for Brent. We expect WTI to trade $6/bbl below Brent next year. Chart 3Lower OPEC 2.0 Production Expected Lower OPEC 2.0 Production Expected Lower OPEC 2.0 Production Expected In addition to the above assumptions, we also believe KSA and its Gulf allies will maintain their production cuts in 2H19, to make room for higher U.S. shale production once Permian Basin pipeline transportation is de-bottlenecked. With the exception of the 2014 – 16 price collapse, which resulted from the ill-fated market-share war launched by OPEC in an attempt to limit Iran’s revenues when it returned to export markets following the removal of export sanctions in 2015, OPEC’s modus operandi has been to reduce production to make room for non-OPEC production increases.8 Canada’s Takeaway Dilemma Unlike the Permian Basin, Canada’s takeaway bottlenecks – i.e., insufficient pipeline capacity to move all of the oil-sands crude it can produce south to the U.S. refining or Gulf Coast export market – are not likely to be resolved in the near future. This will reduce investment in oil-sands development, and keep pressure on oil producers selling their crude on a Western Canadian Select (WCS) basis, the Canadian benchmark. At present, there is a large takeaway deficit in the Western Canadian Sedimentary Basin (WCSB). Pipeline capacity has been maxed out since 2H17. There were five planned pipeline projects in the basin, four of which have been either cancelled or indefinitely delayed – i.e., the Trans Mountain Expansion, Northern Gateway, Energy Est and Keystone XL – while one is expected to be constructed in 4Q19 (i.e., the Line 3 Replacement). The outlook for pipeline capacity does not bode well for WCS prices. Since 2017, around 3mm b/d of needed pipeline infrastructure has been cancelled/delayed. The Enbridge Line 3 Replacement is expected to increase crude delivery to Superior, WI, in 4Q19, by ~ 370k b/d. Absent a major policy or court ruling U-turn, projected pipeline additions will be insufficient to cover Alberta’s growing oil sands surplus until 2022, and possibly beyond (Chart 4).9 Chart 4Expected Pipeline Additions In Canada Fall Short The Third Man At OPEC 2.0's Meeting The Third Man At OPEC 2.0's Meeting This persistent takeaway deficit pushed the WTI – WCS spread past the crude-by-rail cost range (Chart 5). This means prices are signaling the need for additional takeaway capacity – i.e., building additional pipeline, or importantly, additional trains/crews/rail infrastructure – and that production should be reduced. Chart 5WCS Differentials Signal More Takeaway, Less Production Is Required The Third Man At OPEC 2.0's Meeting The Third Man At OPEC 2.0's Meeting Our analysis of takeaway capacity in the WCSB leads us to believe investments in oil sands will be curtailed, which will lead to a slowdown in production starting in 2021 (Chart 6). According to IHS Markit, production growth this year and next is expected to come mainly from projects under construction before 2014. Capex is still low compared to pre-2014 levels (Chart 7). The current WTI – WCS spread should limit production growth to ~ 600k b/d between 2018 and ~ 2022. If, as we expect, the delayed pipelines are built in late 2021- early 2022, investment should start to rise again prior to this. Hence, production growth could resume close to 2022, or slightly thereafter. This is in line with the Canadian National Energy Board’s low-price scenario, in which oil production increases by 600k b/d from now to 2021, and plateau/declines afterward due to lack of investments. Chart 6Expect Lower Oil-Sands Capex Expect Lower Oil-Sands Capex Expect Lower Oil-Sands Capex Chart 7Capex Below Pre-2014 Levels The Third Man At OPEC 2.0's Meeting The Third Man At OPEC 2.0's Meeting The lack of pipeline takeaway capacity has forced crude producers to pay higher rates to move their oil out of the provinces via rail. In the short-term, this is a reasonable – although partial – solution. In theory, Saskatchewan and Alberta have enough loading-terminal capacity to transport all of the excess crude supply above pipeline capacity (Chart 8). Chart 8Takeaway Capacity Can Be Found The Third Man At OPEC 2.0's Meeting The Third Man At OPEC 2.0's Meeting However, loading-terminals are currently underutilized and shared with other commodities produced in the regions.10 Hence, crude-by-rail can only increase by: Taking capacity from other commodities currently using the rail cars, crews and locomotives. However, most of these substitute transportation modes are in already-agreed long- and medium term contracts with the railroad companies (Chart 9). Railroad companies are not willing to give away space paid for by grain shippers, which are long-term reliable customers – as opposed to uncertain crude-oil customers. Earlier this year, railroads said they would only pursue multi-year contracts with oil producers to finance new crews, locomotives, and track capacity: Short-term contracts are too risky, in the event oil shipments stop suddenly. This is ongoing; crude-by-rail volume should continue to rise through the end of the year, and part of next year.11 The fact that there is a low level of uncertainty around the lack of pipeline capacity for the next 3-4 years helps increase rail investments. Chart 9Railroads Make Grain Contracts First Priority The Third Man At OPEC 2.0's Meeting The Third Man At OPEC 2.0's Meeting Investing in new equipment, crews and infrastructures. The Alberta Government recently announced it wants the Federal government to invest in new rail cars and infrastructure to increase takeaway capacity by 120k to 140k b/d. However, those new rail cars are only projected to start moving oil in 2H19.12 We expect crude-by-rail volumes to increase in the next few months, but the growth should slow or even flatten in 1H19, given new capacity takes time to be brought on line and other commodities already have a claim on most of the rail space.13 Crude-by-rail growth should resume in 2H19, however. We expect crude-by-rail volume to reach ~ 300k b/d by year-end and ~ 450k b/d by 4Q19. This will help alleviate some of the pressure on WCS prices (Chart 10). The fact that no pipelines are expected in the next 3 years or so suggests the WCS discount to WTI will remain in the crude-by-rail price range shown in Chart 5 – i.e., a $15-to-$22/bbl discount over the quality discount for heavy sour crude vs. the light-sweet WTI benchmark.14 Chart 10Crude-by-rail Should Increase In 2H19 The Third Man At OPEC 2.0's Meeting The Third Man At OPEC 2.0's Meeting As bad as things sound for Canadian producers, there are two potentially important – and conflicting – regulatory and policy wildcards that could affect our projections. First the good news, then the bad news: Government-imposed production cuts: The current abnormally wide WCS spreads are caused by the marginal excess production above pipeline and rail capacity. We estimate this excess to be ~ 200k b/d. This means the marginal price received for producing these volumes sets the selling prices of the other ~ 4mm b/d produced in Canada by ~ $10-15/bbl. Therefore, as suggested by two leading Canadian oil producers, a relatively small government-imposed production reduction would have a large positive effect on WCS prices (Chart 11). As present, we assign a low probability to this outcome. Chart 11Government-Imposed Production Cut Would Lift Prices The Third Man At OPEC 2.0's Meeting The Third Man At OPEC 2.0's Meeting IMO 2020 regulation: The January 1, 2020, implementation of the International Maritime Organization’s (IMO’s) sulphur cap on marine fuels of 0.50% could contribute to widening the WCS price discount. A recent study by CERI concluded the new regulation would decrease prices of heavy sour crude, by driving down demand for these grades. This would significantly affect Canadian oil, as it competes with other heavy streams for limited complex refining capacity worldwide. According to CERI’s analysis, IMO 2020 regulation alone could maintain the differential at $31-33/bbl. We will be exploring the implications of IMO 2020 in future research. Bottom Line: Canada’s oil industry faces a Herculean lift if it is to attract capital to grow. Pipeline constraints limiting crude takeaway capacity to the south in the WCSB strongly suggest investment in oil sands will be curtailed, which will lead to a slowdown in production starting in 2021. Crude-by-rail is a palliative, which does not fully address the underlying transportation bottlenecks limiting the growth of the Canadian crude-oil industry.     Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com   Footnotes 1      Please see BCA Research’s Commodity & Energy Strategy Weekly Report “All Fall Down: Vertigo In The Oil Market … Lowering 2019 Brent Forecast To $82/bbl,” published November 15, 2018. It is available at ces.bcaresearch.com. 2     LME stocks are at 10-year lows, and the SHFE’s are just over 20% of their August levels. Please see “METALS – Zinc falls as weaker Chinese demand outweighs supply fears,” published by reuters.com November 26, 2018. 3      This assumes average crude-oil production of 10.1mm b/d by the IMF. Please see the IMF’s Regional Economic Outlook Update for the Middle East, North Africa, Afghanistan, and Pakistan, for May 2018, Statistical Appendix Table 6. 4      Please see the IMF’s Regional Economic Outlook Update for the Middle East, North Africa, Afghanistan, and Pakistan, for May 2018, Statistical Appendix Table 22. 5      Please see the IMF’s Regional Economic Outlook Update for the Middle East, North Africa, Afghanistan, and Pakistan, for May 2018 (p. 8). 6      The Russian seizure of Ukrainian ships and sailors earlier this week could prompt additional sanctions from the West. In its immediate aftermath, the ruble fell, credit-default insurance rates rose and the yield on local-currency bonds approached 9% p.a. Please see “Russian Assets Retreat as Ukraine Clash Revives Sanctions Risk,” published by bloomberg.com November 26, 2018. See also the IMF’s Country Report No. 18/275, Russian Federation, published in September 12, 2018, press release, and the full report published July 17, 2018. 7      Please see “In Trump’s Saudi Bargain, the Bottom Line Proudly Wins Out,” published by the nytimes.com October 14, 2018. 8      A failure by OPEC 2.0 to cut production and an extension of waivers on the Iran sanctions could add as much as 1.2mm b/d of oil to the market next year, which would renew the global inventory-building cycle and push Brent prices down by $20/bbl versus our forecasts, in our estimation. 9      Prior to the cancellation/delay by U.S. and Canadian Courts of the Kinder Morgan Trans Mountain and TransCanada Keystone XL pipeline projects – and before the record blow-out of the WTI – WCS basis – the Canadian Association of Petroleum Producers (CAPP) projected Canadian production would grow from 4.5mm b/d in 2018 to 6.1mm b/d in 2035. All of this growth is projected to come from the WCSB oil sands. On August 30, the Canadian Federal Court of Appeal ruled against the expansion of the Trans Mountain pipeline. The National Energy Board (NEB) now has to conduct a new review, which will require it to increase consultations with indigenous groups, and to assess the impact of marine shipping before submitting the project. On November 8, U.S. District Judge in Montana issued a ruling on the Keystone XL pipeline forcing the State Department to analyze new information in the environmental assessment of the project. The project is not cancelled, but it now needs a new environmental impact assessment. Please see the CAPP’s July report entitled 2018 Crude Oil Forecast. 10     Please see the CAPP’s July report entitled “2018 Crude Oil Forecast: Markets And Transportation,” for more details. 11     Cenovus signed three-year deals to transport approximately 100,000 barrels per day (bbls/d) of heavy crude oil from northern Alberta to the U.S. by rail. (https://www.cenovus.com/news/news-releases/2018/09-26-2018-cenovus-signs-rail-deals-to-transport-oil-to-u.s.-gulf-coast.html). GE Transportation announced CN ordered 60 new locomotives on top of an order of 200 made in December 2017 (http://trn.trains.com/news/news-wire/2018/09/05-cn-orders-60-locomotives-from-ge). 12     Please see “Desperate to move crude, Alberta may buy trains alone if Canada balks,” published November 22, 2018, by ca.reuters.com. The odds of the Federal government participating in this investment are low: First, the request wasn’t mentioned in the most recent Federal economic statement. Second, the Federal government already stepped in to buy the controversial Trans Mountain pipeline; Ottawa is now focused on making sure this will be approved in court challenges. 13     Both Canadian National and Canadian Pacific railroads mentioned their priority was to handle the Canadian grain harvest during the “challenging winter months” before allocating rail space to crude oil. Grains-to-oil rail space substitution should increase in spring 2019. http://trn.trains.com/news/news-wire/2018/11/14-cn-and-cp-expect-to-bring-on-even-more-crude-oil-traffic-next-year 14     The discount to get Canadian crude to Cushing, OK, where the NY Mercantile Exchange’s WTI futures contract delivers, can increase by $5/bbl for Gulf deliveries. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table   Trades Closed In 2018 The Third Man At OPEC 2.0's Meeting The Third Man At OPEC 2.0's Meeting Trades Closed in Summary of Trades Closed in 2017 The Third Man At OPEC 2.0's Meeting The Third Man At OPEC 2.0's Meeting

Dear Client, Early next week, we will be sending you our BCA Outlook 2019 - our annual dialogue with the bearishly inclined Mr. X and his family. In this report, BCA editors will highlight the most impactful themes for the global economy next year, and the opportunities and risks they create for international asset markets. Next Friday, we will also send you our take on the implications of this discussion for the FX market. Best regards, Mathieu Savary, Vice President Foreign Exchange Strategy Highlights A bearish consensus is forming around the dollar for 2019 as U.S. growth is falling prey to global economic deterioration. However, slowing global growth and inflation create the best environment for the dollar, suggesting the greenback could perform very well in early 2019. While EUR/USD should trade below 1.10 before mid-2019, the dollar should be strongest against the AUD, the NZD and the SEK. The yen faces a trickier picture. With a low degree of conviction, we anticipate USD/JPY to depreciate; but with a high level of confidence, we foresee additional strength in the JPY against the AUD, the NZD and the SEK; EUR/JPY should move below 120. Close short CAD/NOK. Feature The end of the year is approaching, which means that like BCA, banks and research houses around the world are rolling out their major forecasts for the upcoming year. The near-uniform bearishness toward the greenback of the current vintage of forecasts has struck us. Our contrarian streak inclines us to re-assert our bullish dollar stance, but being contrarian for the sake of it is often the perfect recipe to lose money. Welcome To The Jungle A bearish tone on the dollar appears justified right now. Speculators hold near-record long bets on the dollar, yet U.S. economic data seem to finally be succumbing to the gravitational pull of slowing global economic activity. U.S. core inflation has disappointed, orders have been weak, capex intentions have softened, the Conference Board's leading economic indicator has rolled over, and financial conditions have tightened as junk bonds have sold off. This combination could easily generate the perfect recipe for the dollar to sell off. The dollar's strength has been rooted in the divergence of U.S. growth from a weak world economy (Chart I-1). As the narrative goes, without U.S. strength, the Federal Reserve will not be tightening policy anymore, and the dollar will sag. Interest rate markets are already on this page, as after the December meeting they only foresee one more rate hike over the coming two years. Chart I-1Will The Dollar Lose A Key Support? Will The Dollar Lose A Key Support? Will The Dollar Lose A Key Support? Despite this tantalizing narrative, the dollar rarely weakens because of poor U.S. growth alone. To the contrary, dives in our diffusion index of 16 key U.S. economic variables are most often associated with a strengthening greenback (Chart I-2). The recent sharp fall in this diffusion index would actually point to an appreciating USD. Chart I-2The Plot Thickens The Plot Thickens The Plot Thickens This relationship is obviously paradoxical. It exists because the dollar is not a normal currency: it is the premier reserve currency of the world. Resting at the center of the global financial system, the dollar is more sensitive to global growth and inflation conditions than to U.S. growth and policy alone. As Chart I-3 shows, the dollar's behavior is a function of where we stand in the global economic and inflation cycle. We looked at the performance of G-10 currencies versus the dollar since 1986, decomposing the period in four samples based on trends in global activity and global headline inflation. We observed the following patterns: When global growth is accelerating but inflation is decelerating, the dollar tends to weaken, especially against the very pro-cyclical AUD, NZD and SEK (Bottom right quadrant). This is often an environment observed in the early days of a business cycle recovery. When global growth and global inflation are both accelerating, the dollar also tends to weaken, but the pattern is much less clear than in the previous stage (Top right quadrant). This is generally a mid-cycle environment. When global growth is decelerating but global inflation is accelerating, the dollar weakens much more clearly than in the mid-cycle stage (Top left quadrant). In this stage, global growth has begun to decelerate but is still elevated. Risk assets are doing well, but some clouds are gathering on the horizon. European currencies perform best. The most distinct change in the dollar's behavior happens when both global growth and global inflation are decelerating (Bottom left quadrant). In this context, the dollar is strong across the board. This is an end-of-cycle environment where global growth is poor and inflation sags. Investors become very risk averse and they favor the dollar. Commodity currencies and Scandinavian currencies are the worst performers, while the yen is the best. We were surprised that the yen did not manage to appreciate during the periods described by the bottom-left quadrant. However, this is due to the long sample used (since 1986). Prior to the mid-1990s, the yen was a decidedly pro-cyclical currency. This taints the study's overall results. If we only use a shortened time span, the yen in fact appreciates in the last stage of the global business cycle. The yen is the only currency to experience such a sharp regime shift in its relationship to the global business cycle. Chart I-3The Dollar And The Global Business Cycle Appetite For Destruction? FX Investing For Slowing Global Growth And Inflation Appetite For Destruction? FX Investing For Slowing Global Growth And Inflation Bottom Line: Dividing the business cycle into four periods shows that only when global growth and inflation are very weak can the dollar unequivocally rally. This is exactly what we would anticipate of a reserve currency. Investors flock to it when they are looking for safety. Moreover, since being the global reserve currency also means that most of the world's foreign-currency borrowing is in dollars, periods of tumult force debtors to repay their debt, prompting them to buy the greenback in the process. Finally, the low beta of the U.S. economy to the global industrial cycle only adds fuel to the fire, as it means that U.S. growth outperforms global growth when global activity deteriorates meaningfully. Paradise City Under this lens, the dollar's strength this year was rather impressive. We have seen global growth slow, but global inflation accelerate. This could have been a disastrous year for the dollar, but it was not. Markets have been sniffing out slower growth and its potentially deflationary impact; hence, the dollar has responded well. Moreover, the dollar started the year trading at a 5% discount to its fair value, and investors were massively short. Finally, as we have previously showed, the dollar is the epitome of momentum currencies within the G-10 space, and this year, our momentum measure flagged a very bullish signal for the dollar (Chart I-4).1 Chart I-4Momentum Has And Continues To Support The Greenback Momentum Has And Continues To Support The Greenback Momentum Has And Continues To Support The Greenback While the dollar has already been strong, the next three to six months could generate considerably more dollar strength. The dollar may not be cheap anymore, but as we argued last week, it is not expensive either.2 Moreover, while investors are already very long the dollar - a source of concern for us - momentum still favors the greenback. Finally, the global economy might spend some time in the bottom-left quadrant described above where global growth and global inflation both decelerate - the quadrant where the dollar strengthens. Thus, both momentum and economics could line up to enhance the dollar's appeal. First, we have already highlighted that global growth is in the process of weakening. Under the weight of China's deleveraging efforts, of uncertainty surrounding global trade under the Trump administration, and of the tightening in EM financial conditions, global export growth has been flailing.3 Now, our global economic and financial advance/decline line shows that enough variables are pointing in a growth-negative direction that global industrial production - not just orders and surveys - is set to deteriorate sharply (Chart I-5). Chart I-5Global Growth Will Slow Materially In The First Half Of 2019 Global Growth Will Slow Materially In The First Half Of 2019 Global Growth Will Slow Materially In The First Half Of 2019 This message is confirmed by the OECD's leading economic indicator, which is falling faster than it was in late 2015. Most crucially, the very poor performance of EM carry trades financed in yen, which have been a reliable forecaster of global industrial activity, point to a sharp deterioration of our Global Nowcast (Chart I-6), an indicator that measures the evolution of global industrial activity while bypassing the long publishing lags inherent in global IP statistics. Chart I-6The Canaries Are Suffocating The Canaries Are Suffocating The Canaries Are Suffocating Second, while global inflation has been on an uptrend, we expect it to soon relapse, potentially for six months or so. To begin with, we are already seeing some key global inflation measures soften. Recent U.S. core inflation releases have disappointed, Japan's GDP deflator has grown more negative, Germany's producer prices have decelerated, and both producer and core consumer prices in China are slowing sharply. If we are to believe financial markets, this development has further to run. The change in 10-year and 5-year/5-year forward U.S. inflation break-evens has collapsed, and the performance of U.S. industrial stocks relative to utilities suggest that global core inflation will soon decelerate noticeably (Chart I-7). Additionally, the annual total returns of EM equities relative to EM bonds, adjusted for their mutual volatility, has fallen, which normally also foreshadows a decline in underlying global inflation (Chart I-8). Chart I-7U.S. Financial Market Point To Slower Global Inflation... U.S. Financial Market Point To Slower Global Inflation... U.S. Financial Market Point To Slower Global Inflation... Chart I-8...So Do EM Stocks And Bonds ...So Do EM Stocks And Bonds ...So Do EM Stocks And Bonds The trend in some of the most important globally traded good prices is also very worrisome for inflation hawks, at least for the first half of 2019. Oil has fallen 26% since its October peak, but also, after rising nearly 90% from April to August, the Baltic Dry index has tumbled by nearly 45%. Another risk could exacerbate these deflationary forces: the Chinese yuan. The Chinese authorities are afraid of the potentially deeply negative impact on their economy of a trade war with the U.S. As a result, they have slowly been injecting monetary stimulus into the economy and are also adjusting fiscal policy to support the Chinese consumer. However, until now, these measures have not been enough to lift Chinese growth and investment. Chinese interest rates are thus likely to continue to lag behind U.S. rates. Deeper cuts to the reserve requirement ratio for commercial banks are also forthcoming. Historically, these developments have been associated with a weaker renminbi (Chart I-9). Chart I-9A Falling CNY Will Further Curtail Inflation A Falling CNY Will Further Curtail Inflation A Falling CNY Will Further Curtail Inflation A softening CNY is deflationary for the world for three reasons: It decreases the purchasing power of China abroad; it cuts Chinese export prices; and it forces competitors to China to also lower their prices and let their currencies depreciate in order to maintain their own competitiveness in international markets. In other words, a falling yuan unleashes China's own deflationary forces onto the rest of the world. Bottom Line: While momentum has already been a tailwind for the dollar, now the global economy is likely to enter the quadrant where both growth and inflation decelerate. This means the greenback is likely to pick up an additional strong tailwind. Stay long the dollar. Nightrain Based on this analysis, the first half of 2019 could be very positive for the dollar. The Bottom left quadrant of Chart I-3 implies that EUR/USD is unlikely to suffer the greatest downside. Nonetheless, based on our preferred fair-value model for the euro - which is based on real short-rate differentials, yield curve slope differences, and the price of lumber relative to copper - the common currency needs to move below 1.1 before trading at a discount (Chart I-10). We expect the euro will settle between 1.10 and 1.05. Chart I-10EUR/USD Will Fall Below 1.1 EUR/USD Will Fall Below 1.1 EUR/USD Will Fall Below 1.1 If business cycle analysis is any guide, the dollar should shine most brightly against commodity currencies - the AUD and NZD in particular - and Scandinavian currencies. We closed our long NZD trades last week, and this week's analysis implies completely curtailing our positive bias toward the kiwi. Positive domestic economic results have lifted the AUD, but slowing global growth and inflation will hurt this very pro-cyclical economy. A key support for the expensive AUD will dissipate as quickly as it appeared. We had sold CAD/NOK, but this trade is not panning out. Global business cycle dynamics suggest that we should terminate this bet. Slowing global growth and inflation historically hurt the NOK more than the CAD. As Chart I-11 shows, under these circumstances, CAD/NOK does not depreciate, it appreciates. However, we remain committed to our long-term short AUD/CAD trade. This cross performs poorly in this quadrant of the global business cycle. This view is reinforced by the fact that Robert Ryan, BCA's head of commodities, continues to favor energy over base metals. Furthermore, the Canadian government unveiled C$14billion of corporate tax cuts this week, creating a marginal additional positive for the Canadian economy. We therefore do not expect AUD/CAD to break above the important technical resistance it currently faces. Instead, it is likely to embark on the last leg of a downtrend started in March 2017, which could culminate with AUD/CAD trading between 0.88 and 0.86 (Chart I-12). Chart I-11The Global Business Cycle Votes Nay To Short CAD/NOK, But Yea To Long AUD/CAD Appetite For Destruction? FX Investing For Slowing Global Growth And Inflation Appetite For Destruction? FX Investing For Slowing Global Growth And Inflation Chart I-12Attractive Spot To Sell AUD/CAD Attractive Spot To Sell AUD/CAD Attractive Spot To Sell AUD/CAD The yen is potentially the trickiest of all the currencies. At face value, the global business cycle analysis suggests the yen could depreciate against the dollar, but as we argued, this is an artefact of the long sample used in this analysis. A shorter sample would show the yen appreciating against the dollar. We are inclined to agree with this conclusion. Slowing global growth and inflation as well as a strong trade-weighted dollar could very well put a bid under the price of Treasury bonds over the next few months, especially as speculators are still large sellers of the whole U.S. government bond universe (Chart I-13). Since the yen remains broadly inversely correlated to Treasury yields, it may appreciate against the dollar over the coming three to six months. Chart I-13Extreme Positioning And A Poor Global Business Cycle Outlook Point To A Tactical Rally In Treasurys... Extreme Positioning And A Poor Global Business Cycle Outlook Point To A Tactical Rally In Treasurys... Extreme Positioning And A Poor Global Business Cycle Outlook Point To A Tactical Rally In Treasurys... Our view has been and remains that the yen offers its most attractive reward-to-risk ratio on its crosses, not against the U.S. dollar. The business cycle analysis confirms that the yen has upside against all the other currencies when both global growth and inflation slows (Chart I-3, bottom left quadrant). The yen should, therefore, offer plentiful upside against the AUD, the NZD, the SEK and the NOK. Moreover, since the beginning of the year, a core view of this publication has been that EUR/JPY would depreciate4 - a trend that has materialized, albeit in a volatile fashion. Since the global business cycle is likely to put downward pressure on global yields for another three to six months, it should also push EUR/JPY lower (Chart I-14). Hence, a move in EUR/JPY below 120 is likely over the coming months. Chart I-14...Which Will Hurt EUR/JPY ...Which Will Hurt EUR/JPY ...Which Will Hurt EUR/JPY Bottom Line: While EUR/USD could fall slightly below 1.1, the greenback is likely to experience its sharpest upside against the AUD, NZD, SEK and NOK. While selling CAD/NOK does not work when global growth and inflation decelerate, selling AUD/CAD does. The JPY is likely to experience more upside against the dollar, but the JPY is most attractive against commodity currencies and the euro. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Special Report, titled "Riding The Wave: Momentum Strategies In Foreign Exchange Markets", dated December 8, 2017, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report, titled "Six Questions From The Road", dated November 16, 2018, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report, titled "Clashing Forces: The Fed And EM Financial Conditions", dated October 19, 2018, available at fes.bcaresearch.com 4 Please see Foreign Exchange Strategy Weekly Report, titled "The Unstoppable Euro?", dated January 19, 2018, and Foreign Exchange Strategy Weekly Report, titled "The Yen's Mighty Rise Continues", dated February 16, 2018, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the U.S. has been mixed: Capacity utilization came in above expectations, coming in at 78.4%. However, both initial jobless claims and continuing jobless claims surprised negatively, coming in at 224 thousand and 1.688 million. Finally, durable goods orders also disappointed expectations DXY has been roughly flat this week. Several indicators point to a slowdown on economic data. At face value this could imply that the dollar could fall. However, falling oil prices, point to a slowdown in global inflation. This factor, alongside slowing global growth has historically been very positive for the U.S. dollar. Thus, we maintain our long dollar position. Report Links: Six Questions From The Road - November 16, 2018 Updating Our Intermediate Timing Models - November 2, 2018 In Fall, Leaves Turn Red, The Dollar Turns Green - October 12, 2018 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data in the euro area has been mixed: Both core and headline inflation came in line with expectations, coming in at 1.1% and 2.2%, respectively. Headline inflation in Italy also came in line with expectations, at 1.6%. EUR/USD has risen by roughly 0.5% this week. Overall, we continue to be bearish on the euro, given that we expect an environment of declining growth and inflation, which usually is negative for EUR/USD. Moreover, large exposure to vulnerable emerging markets by European banks will continue to be a drag on how much the ECB can tighten policy. Report Links: Six Questions From The Road - November 16, 2018 Evaluating The ECB's Options In December - November 6, 2018 Updating Our Intermediate Timing Models - November 2, 2018 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan has been mixed: The All Industry Activity Index monthly change underperformed expectations, coming in at -0.9%. Meanwhile, national inflation ex-fresh food came in line with expectations at 1%. Finally, national inflation also came in line with expectations, coming in at 1.4%. USD/JPY has been flat this week. We remain positive on the trade-weighted yen, given that the continued slowdown in global growth, fueled by the dual tightening of policy by Chinese authorities and the Fed, will help safe haven currencies like the yen. Moreover, the current selloff in U.S. markets could also provide a boon for this currency if it forces the Fed to tamper its hawkishness. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Will Rising Wages Cause An Imminent Change In Policy Direction In Europe And Japan? - October 5, 2018 Rhetoric Is Not Always Policy - July 27, 2018 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 GBP/USD has risen by 0.9% this week. The market reacted positively to the draft of the Brexit agreement. Even if risks have begun to decline, the all clear for the pound has not been reached as political risks will continue to regularly inject doses of volatility into British assets. Moreover, the strength in the dollar should continue to weigh on cable. Report Links: Six Questions From The Road - November 16, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 AUD/USD has been flat this week. We are most negative on this currency within the G10, given that the AUD is highly sensitive to the Chinese industrial cycle, which will continue to slow down, as Chinese authorities keep cleaning credit excesses in the economy. Moreover, policy tightening by the Fed will provide a further headwind to cyclical plays like the AUD. We are short AUD/CAD within our portfolio, as we believe that global inflation will start to roll over. This deceleration in prices, coupled with slowing growth will provide a dangerous cocktail for this cross. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Policy Divergences Are Still The Name Of The Game - August 14, 2018 What Is Good For China Doesn't Always Help The World - June 29, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 NZD/USD has been flat this week. While we were positive the NZD and capitalized on this view, we are becoming more cautious. We cannot rule out any further short-term upside, but on a six month basis, the NZD will likely experience heavy downside, as slowing global growth and inflation are major hurdles for this currency. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 In Fall, Leaves Turn Red, The Dollar Turns Green - October 12, 2018 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 USD/CAD has risen by 0.6% this week. The weakness in oil prices have caused the Canadian dollar to be one of the worst performing currencies in the G10 in recent weeks. We are reticent to be too bullish on the CAD, given that markets are now pricing in a BoC that will be more hawkish than the Fed. Nonetheless the CAD tends to outperform other commodity currencies when the global business cycle slows. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 EUR/CHF has fallen by 0.7% this week. While global volatility can temporarily support the swiss france versus the euro, w continue to be bearish on the franc on a 12 to 18 months basis, given that Swiss growth and inflation remain too tepid for the SNB to hike policy rates. This point is confirmed by the recent rollover in industrial production. Moreover, the SNB will also have to intervene in currency markets if the franc becomes more expensive in response to the current risk-off environment. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 USD/NOK has risen by 0.4% this week. Overall, we expect for the krone to have further downside as oil continues to fall while U.S. rates continue to rise. Moreover, if the fall in oil prices causes a large fall in inflation the krone could depreciate even more against the CAD, as this cross has historically fallen when this particular set of circumstances occur. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 USD/SEK has been flat this week. Overall, we are bullish on the krona on a long-term basis. After all, the Riksbank is on the verge of beginning a tightening cycle, as imbalances in the Swedish economy are only growing more dangerous. The optimism on domestic factors is tempered by global risks. The krona tends to perform very poorly when global growth slows, as Sweden is very exposed to the gyrations of the global economy. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Dear Client, Next week, I am on the road in the Middle East visiting clients and teaching the BCA Academy Principles of Global Macro course. There will be no regular Weekly Report on November 9th. Instead, we will be sending you a Special Report on November 6th written by my colleague Rob Robis, who runs BCA's Global Fixed Income Strategy service. In this piece, Rob will be discussing the outlook for Euro Area monetary policy and its implications for rate markets and the euro. This is an especially relevant topic as the end of the ECB's Asset Purchase Program is scheduled to soon materialize. I trust you will find this report both interesting and informative. Best regards, Mathieu Savary, Vice President Foreign Exchange Strategy Highlights Uncovered Interest Rate Parity still works for currencies. However, it needs to be based on a combination of short- and long-term real rates. Currencies are also affected by global risk appetite, as approximated by corporate spreads and commodity prices. Based on our timing models, the dollar is now fairly valued on short-term basis. However, slowing global growth and robust U.S. activity suggest that the dollar has room to rally further, with our models pointing to a move in the greenback's favor. These conflicting forces suggest the dollar's easy gains are behind us, and any further dollar rally will prove much more volatile. Feature In July 2016, in a Special Report titled, "In Search Of A Lost Timing Model," we introduced a set of intermediate-term models to complement our long-term fair value models for various currencies.1 These groups of models provide additional discipline - a sanity check if you will - to our regular analysis. Additionally, these models can help global equity investors manage their currency exposure, thanks to their ability to increase the Sharpe ratio of global equity portfolios vis-Ã -vis other hedging strategies, and also for a host of base-currencies.2 In this report, we review the logic underpinning these intermediate-term models and provide commentary on their most recent readings for the G10 currencies vis-Ã -vis the USD. UIP, Revisited The Uncovered Interest Rate Parity (UIP) relationship is at the core of this modeling exercise. This theory suggests that an equilibrium exchange rate is what will make an investor indifferent between holding the bonds of Country A or Country B. This means that as interest rates rise in Country A relative to Country B, the currency of Country B will fall today in order to appreciate in the future. These higher expected returns are what will drive investors to hold the lower-yielding bonds of Country B. There has long been debate as to whether investors should focus on short rates or long rates when looking at exchange rates through the prism of UIP. This debate has regained vigor in the past six months as the dollar has greatly lagged the levels implied by 2-year rate differentials (Chart 1). Research by the Federal Reserve and the IMF suggests that incorporating longer-term rates to UIP models increase their accuracy.3 This informational advantage works whether policy rates are or aren't close to their lower bound.4 Chart 1Interest Rate Parity: Generally Helpful, But... Interest Rate Parity: Generally Helpful, But... Interest Rate Parity: Generally Helpful, But... Incorporating long-term rates as an explanatory variable increases the performance of UIP models because exchange rate movements not only reflect current interest rate conditions, but currency market investors also try to anticipate the path of interest rates over many periods. By definition, long-term bonds do just that, as they are based on the expected path of short rates over their maturity - as well as a term premium, which compensates for the uncertain nature of future interest rates. There is another reason why long-term rate differential changes improve the power of UIP models. Since UIP models are based on the concept of indifference among investors between assets in two countries, changes in the spreads between 10-year bonds in these two countries will create more volatility in the currency pair than changes in the spreads between 3-month rates. This is because an equivalent delta in the 10-year spread will have a much greater impact on the relative prices of the bonds than on the short-term paper, courtesy of their much more elevated duration. To compensate for these greater changes in prices, the currency does have to overshoot its long-term PPP to a much greater extent to entice investors trading the long end of the curve. Bottom Line: The interest rate parity relationship still constitutes the bedrock of any shorter-term currency fair value model. However, to increase its accuracy, both long-term and short-term rates should be used. Real Rates Really Count Another perennial question regarding exchange rate determination is whether to use nominal or real rate differentials. At a theoretical level, real rates are what matter. Investors can look through the loss of purchasing power created by inflation. Therefore, exchange rates overshoot around real rate differentials, not nominal ones. On a practical level, there are additional reasons to believe that real rates should matter, especially when trying to explain currency moves beyond a few weeks. Indeed, various surveys and studies on models used by forecasters and traders show that FX professionals use purchasing power parity as well as productivity differential concepts when setting their forex forecasts.5 Indeed, as Chart 2 illustrates, real rate differentials have withstood the test of time as an explanatory variable for exchange rate dynamics, albeit with periods where rate differentials and the currency can deviate from one another. Chart 2Real Rates Work Better Over The Long Run Real Rates Work Better Over The Long Run Real Rates Work Better Over The Long Run It is true that very often, nominal rate differentials can be used as a shorthand for real rate differentials, as both interest rate gaps tend to move together. However, regularly enough, they do not. In countries with very depressed inflation expectations (Japan immediately comes to mind), nominal and real rate differentials can in fact look very different (Chart 3). With the informational cost of incorporating market-based inflation expectations being very low, we find the shorthand unnecessary when building UIP-based models. Chart 3Real And Nominal Rate Spreads Can Differ Real And Nominal Rate Spreads Can Differ Real And Nominal Rate Spreads Can Differ Finally, it is important to remark that in environments of high inflation, inflation differentials dominate any other factor when it comes to exchange rate determination. However, the currencies discussed in this report currently are not like Zimbabwe or Latin America in the early 1980s. Bottom Line: When considering an intermediate-term fair value model for exchange rates, investors should focus on real - not nominal - long-term rate differentials. Global Risk Aversion And Commodity Prices Global risk appetite is also a key factor in trying to model exchange rates. Risk-aversion shocks tend to lead to appreciation in the U.S. dollar, which benefits from its status as the global reserve currency.6 Much literature has focused on the use of the VIX as a gauge for global risk appetite. Our exercise shows stronger explanatory power with options-adjusted spreads on junk bonds (Chart 4). Chart 4The Dollar Benefits From Global Stresses The Dollar Benefits From Global Stresses The Dollar Benefits From Global Stresses Commodity prices, too, play a key role. Historically, commodity prices have displayed a very strong negative correlation with the dollar.7 This correlation is obviously at its strongest for commodity-producing nations, as rising natural resources prices constitute a terms-of-trade shock for them. However, this relationship holds up for the euro as well, something already documented by the European Central Bank.8 The Models The models for each cross rate are built to reflect the insight gleaned above. Each cross is modeled on three variables, with the model computed on a weekly timeframe. Real rates differentials: We use the average of 2-year and 10-year real rates. The rates are deflated using inflation expectations. Global risk appetite approximated by junk OAS. Commodity prices: We use the Bloomberg Continuous Commodity Index. For all countries, the variables are statistically highly significant and of the expected signs. These models help us understand in which direction the fundamentals are pushing the currency. We refer to these as Fundamental Intermediate-Term Models (FITM). We created a second set of models, based on the variables above, which also include a 52-week moving average for each cross. The real rates differentials, junk spreads and commodity prices remain statistically very significant and of the correct sign. They are therefore trend- and risk-appetite adjusted UIP-deviation models. These models are more useful as timing indicators on a three- to nine-month basis, as their error terms revert to zero much faster. We refer to these as Intermediate-Term Timing Models (ITTM). Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com The U.S. Dollar To model the dollar index (DXY), we used two approaches. In the first one, we took all the deviation from fair value for the pairs constituting the index, based on their weights in the DXY. In the second approach, we ran the model specifically for the DXY, using the three variables described above. U.S. real rates were compared to an average of euro area, Japanese, Canadian, British, Swiss and Swedish real rates, weighted by their contribution to the DXY. We then averaged both approaches, which gave us very similar results to begin with. Currently, there is no evident mispricing in the USD, as it trades near fair value when compared to both the FITM (Chart 5) and ITTM. While this means that the easy part of the dollar rally is behind us, it does not imply that the rally is over. As Chart 6 illustrates, periods of dollar strength tend to end when the dollar trades at a 5% premium to the ITTM. This would imply that a move to 102 on the DXY is likely over the coming months. Moreover, the widening interest rate differential between the U.S. and the rest of the world, as well the bout of rising volatility the world is experiencing, should continue to push the fair values of both the FITM and ITTM higher. Chart 5Fundamentals Continue To Help The Dollar Fundamentals Continue To Help The Dollar Fundamentals Continue To Help The Dollar Chart 6More Upside Is Possible More Upside Is Possible More Upside Is Possible The Euro As a mirror image to the DXY, there is no evident mispricing in EUR/USD. Currently, based on both the FITM and the ITTM, the euro trades at a small premium to fair value (Chart 7). However, the sell signal generated by the deviation from the ITTM in 2017 is still in place, as periods of overvaluation tend to be followed by periods of undervaluation (Chart 8). This indicator will only generate a buy signal for the euro once EUR/USD falls 5% below equilibrium, or to a level of 1.06. Moreover, this target is a moving one. European growth and inflation continue to disappoint, as the euro area feels the drag of a slowing China and decelerating global growth. This means that interest rate differentials are likely to continue to move in a euro-bearish fashion in the coming months. Hence, the flattening in the FITM that materialized in 2018 is at risk of becoming an outright deterioration. Chart 7Fundamentals For The Euro Are Deteriorating Fundamentals For The Euro Are Deteriorating Fundamentals For The Euro Are Deteriorating Chart 8EUR/USD Is Not Cheap EUR/USD Is Not Cheap EUR/USD Is Not Cheap The Yen In an environment of rising global bond yields, the FITM for the yen continues to trend south, as Japanese rates lag well behind U.S. interest rates (Chart 9). This means the yen is once again trading at a small premium to its FITM, implying that even if global risk assets sell off further, the upside for the yen against the dollar may prove limited. However, the picture for the yen against the ITTM is more benign. The yen is at equilibrium on this basis (Chart 10). However, due to the design of the ITTM, previous periods of overvaluations tend to be followed by periods of undervaluation. As a result, on the basis of this model, the yen could continue to experience downside against the dollar over the coming three to six months. This will be even truer if U.S. bond yields can continue to rise. Chart 9Rate Differentials Continue To Hurt The Yen Rate Differentials Continue To Hurt The Yen Rate Differentials Continue To Hurt The Yen Chart 10More Downside Ahead If U.S. Yields Keep Rising More Downside Ahead If U.S. Yields Keep Rising More Downside Ahead If U.S. Yields Keep Rising The British Pound The GBP/USD has deteriorated in recent weeks, a move that was mimicked by cable itself. As a result, the pound does not show any evident mispricing on this basis against the USD (Chart 11). The ITTM corroborates this message, as GBP/USD trades at a marginal 1% discount to this indicator (Chart 12). This upholds our analysis of September 7, which showed there was little risk premium embedded in the pound to compensate investors for the risks associated with the Brexit negotiations and the cloudy British political climate.9 Since British politics remain a minefield, this lack of valuation cushion suggests that the GBP is likely to continue to swing widely. As a result, a strategy to be long volatility in the pound, or to bet on the reversal of both large upside and downside weekly moves in the GBP, remains our preferred approach. Chart 11Cable Is At Equilibrium Cable Is At Equilibrium Cable Is At Equilibrium Chart 12Small Valuation Cushion Could Be Problem If Political Risk Increases Small Valuation Cushion Could Be Problem If Political Risk Increases Small Valuation Cushion Could Be Problem If Political Risk Increases The Canadian Dollar Despite the softening evident in the Loonie's FITM, the Canadian dollar continues to trade at a substantial discount to this fair value model (Chart 13). However, the FITM for the CAD is at risk of weakening further as oil prices have begun to be engulfed in the weakness that has gripped EM and risk assets globally. Mitigating this message, on the eve of the announcement of the USMCA trade deal, which essentially kept in place the trade relationships that existed between the U.S. and Canada under NAFTA, the Loonie was trading at a 1.5 sigma discount to the ITTM, a level normally constituting a buy signal (Chart 14). As a result, we expect the Canadian dollar to not be as sensitive to commodity price weakness as would have been the case had the CAD traded at a premium to its ITTM. This is one factor explaining why the Canadian dollar remains one of our favorite currencies outside the USD for the coming three to six months. The second favorable factor for the CAD is that the Bank of Canada is likely to hike interest rates at the same pace as the Fed. Hence, unlike with other currencies, interest rate differentials are unlikely to move against the CAD. Chart 13Loonie Trades At A Big Discount To Fundamentals... Loonie Trades At A Big Discount To Fundamentals... Loonie Trades At A Big Discount To Fundamentals... Chart 14...Which Will Help The CAD Mitigate A Fall In Oil Prices ...Which Will Help The CAD Mitigate A Fall In Oil Prices ...Which Will Help The CAD Mitigate A Fall In Oil Prices The Swiss Franc Like the euro, the Swiss franc trades in line with both its FITM and ITTM fair values (Chart 15). Moreover, the CHF has been hovering around its fair value for nearly a year now, which means there is less of a case for an undershoot of the ITTM fair value than for currencies that have experienced recent overshoot (Chart 16). Moreover, if volatility in financial markets remains elevated, and volatility within the bond market picks up, the fair value of the Swissie could experience some upside. However, this is where the positives for the Swiss franc end. The Swiss economy remains mired by underlying deflationary weaknesses, reflecting the lack of Swiss pricing power as well as the tepid growth of Swiss wages. As a result, the interest rate differential components of the models are likely to continue to represent a headwind for the CHF, especially as the Swiss National Bank remains firmly dovish and wants to keep real interest rates at low levels in order to weigh on the franc and also stimulate domestic demand. Based on these bifurcated influences, while we remain negative on the CHF against both the dollar and the euro on a cyclical basis, EUR/CHF may remain under downward pressure over the coming three to six months. Chart 15No Valuation Mismatch... No Valuation Mismatch... No Valuation Mismatch... Chart 16...Implies That The CHF Will Be At The Mercy Of Central Banks ...Implies That The CHF Will Be At The Mercy Of Central Banks ...Implies That The CHF Will Be At The Mercy Of Central Banks The Australian Dollar While the Australian dollar continues to trade at a significant premium against long-term models, it now trades at an important discount against both its FITM and ITTM equilibria (Chart 17). However, the problem for the AUD is that the FITM estimates continue to trend lower as Australian interest rates are lagging U.S. rates, especially in real terms. This is a direct consequence of the Reserve Bank of Australia maintaining the cash rate at multi-generational lows, while the Fed keeps hiking its own policy benchmark. With real estate prices sagging in both Melbourne and Sydney, as well as with a lack of wage growth and inflationary pressures, this down-under dichotomy is likely to remain in place and further weigh on the AUD. Meanwhile, while it is true that the AUD is also trading at a discount to its ITTM, historically, the Aussie has bottomed at slightly deeper levels of undervaluation (Chart 18). When all these factors are taken in aggregate, they suggest that for the AUD to fall meaningfully from current levels, we need to see more EM pain, more Chinese economic weaknesses, and commodity prices following these two variables lower. While this remains BCA's central scenario for the coming three to six months, if this scenario does not pan out the AUD could experience a sharp rebound over that timeframe. Chart 17Discount In AUD Emerging... Discount In AUD Emerging... Discount In AUD Emerging... Chart 18...But Not Yet Large Enough ...But Not Yet Large Enough ...But Not Yet Large Enough The New Zealand Dollar The NZD now trades at an even greater discount to both its FITM and ITTM equilibria than the AUD (Chart 19). In fact, so large is this discount that the ITTM is flashing a buy signal for the kiwi (Chart 20). This further confirms the view that we espoused 3 weeks ago that the NZD was set to rebound. As a result, we remain comfortable with our tactical recommendation of buying NZD/USD and selling GBP/NZD. The long NZD/USD position is definitely the riskier one of the two, as the NZD's upside may be limited if EM markets sell off further. In fact, NZD/USD traded at an even greater discount to its ITTM fair value when EM markets were extremely weak in late 2015 and early 2016. However, EM spreads are narrower and EM equities today trade well above the levels that prevail in those days, implying a margin of safety exists for the NZD. Meanwhile, short GBP/NZD is less likely to be challenged by weak EM asset prices, especially as in a post-Brexit environment the U.K. needs global risk aversion to stay low and global liquidity to remain ample in order to finance its large current account deficit of 3.3% of GDP. Chart 19NZD Is Now So Cheap... NZD Is Now So Cheap... NZD Is Now So Cheap... Chart 20...That It Is A Buy ...That It Is A Buy ...That It Is A Buy The Norwegian Krone The Norwegian krone continues to trade at a large discount to its FITM. However, this pair often experiences large and persistent deviations from this model (Chart 21). Nonetheless, it is important to note that as real interest rate differentials between the U.S. and Norway continue to widen, the fundamental drivers of the NOK are set to deteriorate further. By construction, the ITTM has proven to be a more reliable indicator for the Norwegian krone. While the NOK is currently at fair value on this metric, it is concerning that the upward trend in the ITTM has ended and that the equilibrium value for this currency has begun to deteriorate (Chart 22). As such, if oil prices are not able to find a floor at current levels, USD/NOK is likely to experience additional upside. This is because on a three- to six-month basis, there is not enough of a valuation cushion embedded in the NOK at current levels to prevent the Norwegian krone from experiencing deleterious effects in a weak energy price environment. Chart 21The NOK Fundmentals's Are Still Pointing South The NOK Fundmentals's Are Still Pointing South The NOK Fundmentals's Are Still Pointing South Chart 22...And The NOK Remains Vulnerable Versus The USD ...And The NOK Remains Vulnerable Versus The USD ...And The NOK Remains Vulnerable Versus The USD The Swedish Krona The very easy monetary policy conducted by the Riksbank is the key factor explaining why the Swedish krona remains so weak. Indeed, despite a robust economy, Swedish real interest rates are lagging well behind U.S. rates, which is putting strong downward pressure on the SEK's FITM (Chart 23). Meanwhile, despite the SEK's prodigious weakness, this currency only trades at a modest, statistically insignificant discount to its ITTM (Chart 24). This picture suggests that for the SEK to appreciate, the Riksbank needs to become much more aggressive. It is true that the Swedish central bank has flagged an imminent rise in interest rates, but the pace of increase will continue to lag far behind the Fed's own tightening. Moreover, the weakness in global trade is likely to hamper Swedish growth as Sweden is a small, open economy very influenced by gyrations in global industrial activity. As a result, the current slowdown in global trade may well give the Riksbank yet another excuse to only timidly remove monetary accommodation. This suggests that both the FITM and ITTM for the SEK have downward potential. Chart 23The Riskbank Still Hurts The SEK The Riskbank Still Hurts The SEK The Riskbank Still Hurts The SEK Chart 24...And The Krona Needs To Build A Greater Valuation Cushion ...And The Krona Needs To Build A Greater Valuation Cushion ...And The Krona Needs To Build A Greater Valuation Cushion 1 Please see Foreign Exchange Strategy / Global Investment Strategy Special Report titled, "Assessing Fair Value In FX Markets", dated February 26, 2016, available at fes.bcaresearch.com and gis.bcaresearch.com 2 Please see Foreign Exchange Strategy / Global Asset Allocation Special Reports titled, "Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors", dated September 29, 2017, and "Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors (Part II)", dated October 13, 2017, available at fes.bcaresearch.com and gaa.bcaresearch.com 3 Ravi Balakrishnan, Stefan Laseen, and Andrea Pescatori, "U.S. Dollar Dynamics: How Important Are Policy Divergence And FX Risk Premiums?" IMF Working Paper No.16/125 (July 2016); and Michael T. Kiley, "Exchange Rates, Monetary Policy Statements, And Uncovered Interest Parity: Before And After The Zero Lower Bound," Finance and Economics Discussion Series 2013-17, Board of Governors of the Federal Reserve System (January 2013). 4 Michael T. Kiley (January 2013). 5 Please see Yin-Wong Cheung and Menzie David Chinn, "Currency Traders and Exchange Rate Dynamics: A Survey of the U.S. Market," CESifo Working Paper Series No. 251 (February 2000); and David Hauner, Jaewoo Lee, and Hajime Takizawa, "In which exchange rate models do forecasters trust?" IMF Working Paper No.11/116 (May 2010) for revealed preference approach based on published forecasts from Consensus Economics. 6 Ravi Balakrishnan, Stefan Laseen, and Andrea Pescatori (July 2016) 7 Ravi Balakrishnan, Stefan Laseen, and Andrea Pescatori (July 2016) 8 Francisco Maeso-Fernandez, Chiara Osbat, and Bernd Schnatz, "Determinants Of The Euro Real Effective Exchange Rate: A BEER/PEER Approach," Working Paper No.85, European Central Bank (November 2001). 9 Please see Foreign Exchange Strategy Special Report, titled "Assesing The Geopolitical Risk Premium In the Pound", dated September 7, 2018, available at fes.bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades