Canada

Highlights The bottom in the dollar will have to wait for clearer signs that U.S. inflation has hit a trough. DXY is unlikely to punch below its May 2016 low. We examine balance of payments dynamics across the G10. This analysis shows that while the euro has long-term upside, it is too early to bet on any move above 1.20. The Japanese balance of payment dynamics will deteriorate as the BoJ keeps pressing on the gas pedal. Markets will have to price out rate hikes from the U.K. Feature Our most recent attempt at selling EUR/USD ended promptly in failure, as the euro is currently supported by a perfect storm of factors, making the timing of a reversal of its powerful bull run a tricky exercise. On the one hand, European politics continue to enjoy a re-rating among investors. As 2017 began, observers were worried that France was about to fall under the control of populists - euro-skeptic politicians like Marine Le Pen. This could well have spelled the end of the euro. Instead, the French electorate delivered a pro-market outcome with Emmanuel Macron clinching the keys to the Elysée Palace, and his centrist, pro-reform party now controlling Parliament. Meanwhile, German politics remain steady, and the Italian political risk has been pushed back to 2018. On the other hand, investors started the year expecting a hyperactive Trump presidency that would deliver de-regulation and tax reforms. Instead, the U.S. has a Twitterer-in-Chief and a chaotic White House that has been able to only achieve political paralysis. While political developments have grabbed the most headlines, economics have played an even more crucial role. Most importantly, inflation dynamics have been at the crux of the euro's rally. Namely, U.S. inflation has been a big source of disappointment, as the core PCE deflator has fallen from 1.9% in late 2016 to 1.5% today - a move away from the Federal Reserve's 2% target. As a result, the dollar and interest rates have moved away from discounting the Fed's path as implied by the "dot plot" (Chart I-1). However, our work on capacity utilization and financial conditions highlights that the U.S. inflation slowdown has been a reflection of the lagged impact of massive financial tightening in late 2014, and subsequent deceleration in economic activity. In fact, improvements in both capacity utilization and financial conditions witnessed since then point to a turnaround in inflation this fall (Chart I-2). Chart I-1Downward Move In Inflation Rate Expectations Downward Move In Inflation Rate Expectations Downward Move In Inflation Rate Expectations Chart I-2U.S. Inflation To Trough Soon U.S. Inflation To Trough Soon U.S. Inflation To Trough Soon What should investors do in the meantime? The market will only believe the Fed's hiking intensions once inflation rears its head again. After so many false starts and disappointments, signs that inflation might be coming will not be enough, as narratives of a near-permanent state of zero percent inflation are taking hold of the general discourse. Because investors have purged their excess dollar longs and are now heavily positioned for a euro rally, the dollar downside is currently limited, and a significant breach below the May 5, 2016 low in the DXY is unlikely. However, the dollar-rebound camp will have to wait for clear evidence that U.S. inflation is exiting its doldrums. This is a story for the fall. A Look At Balance-Of-Payments Dynamics The U.S. Chart I-3U.S. Balance Of Payments U.S. Balance Of Payments U.S. Balance Of Payments The U.S. current account deficit has been hovering below -2% of GDP for most of the post-great-financial-crisis period, and therefore has played little to no role in explaining the dollar's moves since 2011. However, the U.S. basic balance (current account plus net foreign direct investments) registered a sharp improvement in 2015 on the back of a surge in net FDI into the U.S. Despite a small pullback in the past 18 months, the U.S. basic balance remains consistent with levels recorded during the dollar bull market of the 1990s (Chart I-3). Portfolio flows in the U.S. have moved back into positive territory after a period of net outflows in 2015 and 2016. Yet, the total amount of net portfolio flows remains very low by historical standards, suggesting investors have not wagered aggressively on the U.S. economy's outperformance. Together, the aggregate U.S. balance-of-payment paints a neutral picture for the U.S. The deep imbalances in the current account and basic balance that prevailed prior to the financial crisis have been purged, but portfolio flows into the U.S. do not show any excessive optimism. In fact, the recent period of dollar weakness will likely help the U.S. balance of payments: It should support the trade balance, and make FDI and portfolio flows more attractive going forward as easing U.S. financial conditions help economic activity and asset returns. The Euro Area Chart I-4Euro Area Balance Of Payments Euro Area Balance Of Payments Euro Area Balance Of Payments Since the euro area crisis, the region's current account has surged to a very large surplus of 3.5% of GDP (Chart I-4). This mostly reflects a large correction of imbalances in peripheral nations. Countries like Spain and Italy have seen their own current account balances morph from deficits of 10.2% of GDP and 3.8% of GDP in 2008 and 2011, respectively, to surpluses of 1.9% of GDP and 2.7% of GDP today. The large contraction in imports on the back of moribund domestic demand has been the key driver of this phenomenon. The euro area remains an exporter of FDIs, experiencing near-constant outflows since 2004. As a result, the euro area's basic balance has not experienced as pronounced an improvement as the current account. It is still nonetheless in surplus - something that did not prevent EUR/USD from experiencing a 25% decline from June 2014 to March 2015. Net portfolio flows in the euro area have moved into deeply negative territory, reflecting massive outflows from the bond market. European investors have also been avid buyers of foreign equities, despite the recent increase in foreign buying of euro area stocks. In aggregate, we would interpret the current balance-of-payments dynamic in Europe as potentially supportive of the euro down the line. Aggregate portfolio flows are so depressed that there is a greater likelihood they will improve than deteriorate. However, while the basic balance and portfolio flows bottomed in 2000, the euro was not able to rally durably until 2002. Together, this suggests the euro is unlikely to re-test parity this cycle, but could remain capped below 1.20 for a few more quarters. Japan Chart I-5Japan Balance Of Payments Japan Balance Of Payments Japan Balance Of Payments Thanks to large investment income emanating from a net international investment position of 62% of GDP, Japan sports a current account surplus 2.5% of GDP greater than its trade balance. However, as the country continues to export capital abroad, it still carries a 3.1%-of-GDP deficit in terms of net FDI. This means that the Japanese basic balance of payments remains around 0% of GDP (Chart I-5). Meanwhile, net portfolio flows into Japan have improved greatly in 2017, explaining the yen's strength this year. While we see more upside for equity inflows into Japan, the efforts by the Bank of Japan to suppress JGB yields are likely to result into continued outflows on the fixed-income front. Since BCA is calling for higher global bond yields, fixed income portfolio outflows are likely to grow bigger, making the recent improvement in the Japanese balance of payments a fleeting phenomenon. This will weigh on the yen. We continue to expect the JPY to be one of the worst-performing currencies over the next 12-18 months. The U.K. Chart I-6U.K. Balance Of Payments U.K. Balance Of Payments U.K. Balance Of Payments Financing the U.K.'s current account deficit of 4% of GDP has taken center stage in the wake of the Brexit vote last year. However, while the trade-weighted pound has depreciated 12% since then, the British basic balance of payments has improved and moved back into positive territory. Net FDI inflows lie behind this stunning development. FDI into the U.K. has been surging since 2016 (Chart I-6). However, the recent slowdown in M&A deals into the U.K. points to a potential end for this GBP support. The key costs of controlling the free movement of people in the U.K. - a demand of Brexit voters - will be the loss of passporting rights for the financial services sector. Since this sector has been the biggest magnet for FDI in the U.K., net FDI could soon become a drag on the basic balance of payments. In contrast to FDI, net portfolio flows into the U.K. have followed the anticipated post-Brexit script, falling from 5% of GDP in Q2 2016 to zero earlier this year. This development was the biggest contributor to the pound's weakness last year. Going forward, the case for the Bank of England to turn hawkish is likely to dissipate as the inflation pass-through from the weak pound dissipates (see below). For the pound to rally further, a continued expansion in global liquidity will be necessary. However, we anticipate global liquidity to deteriorate for the remainder of 2017 as the Fed begins the runoff of its balance sheet, and the PBoC keeps tightening the screws on the bubbly Chinese real estate market. Hence, we would position ourselves for pound weakness against the USD in the second half of 2017. Canada Chart I-7Canada Balance Of Payments Canada Balance Of Payments Canada Balance Of Payments Canada runs a current account deficit of 3% of GDP. This is not a new development. Canada has been running a current account deficit since 2009 (Chart I-7), as weakness in the CAD from 2011 to 2016 was counterbalanced by weak export growth to the U.S. and poor oil prices. From a balance-of-payment perspective, the capacity of the CAD to rally may be limited. A surge in FDI to boost the basic balance of payments is unlikely. In 2001, the Canadian dollar was much cheaper than at present, and the impact of the tech bubble was still influencing M&A inflows into the country. In 2008, oil was trading near US$150/bbl. Today, Canada is a high-cost oil producer in a world of cheap oil, making Canadian oil plays unattractive, at least much more so than in 2007-2008. Additionally, net portfolio inflows into the country are already at near-record high levels, explaining the strong performance of the CAD since January 2016. However, going forward, oil prices are unlikely to double once more, and the combination of elevated Canadian indebtedness along with bubbly house prices and rising interest rates will create headwinds for the Canadian economy. Such an outcome would hurt expected returns on Canadian assets, and thus portfolio flows. However, if the hole in Canadian banks' balance sheets proves much bigger than BCA anticipates, this could prompt a repatriation of funds held abroad by banks - assets that currently equal nearly 50% of their balance sheets, temporarily helping the CAD. Australia Chart I-8Australia Balance Of Payments Australia Balance Of Payments Australia Balance Of Payments While the Australian trade balance has moved back in positive territory, the current account remains in deficit, burdened with negative international incomes associated with a negative net international investment position of -60% of GDP. Yet, because the current account has nonetheless improved, the Australian basic balance of payments is back in positive territory, as net FDI inflows have remained steady around 4% of GDP (Chart I-8). From a balance-of-payments perspective, the Australian dollar looks good. The current account balance is likely to remain well supported as the capex needs of Western Australia have decreased - exerting downward pressure on imports - but new mines are coming online and generating revenues and exports. Meanwhile, portfolio flows in Australia are quite depressed, suggesting some long-term upside as investors seem to be underweight Australian assets. That being said, the Aussie is currently trading at 12% above its long-term fair value. Moreover, any tightening in global liquidity thanks to the Fed and the PBoC could increase the cost of financing Australia's large negative net international investment position, and cause a last down leg in metals prices and the AUD. New Zealand Chart I-9New Zealand Balance Of Payments New Zealand Balance Of Payments New Zealand Balance Of Payments New Zealand's current account has been stable at around -3% of GDP since 2010. While New Zealand has been a constant magnet for FDI (Chart I-9), the positive balance in this account has not been able to lift the national basic balance of payments above the zero line. Interestingly, despite still-higher interest rates offered by New Zealand compared to the rest of the G10, the kiwi has been experiencing net portfolio outflows so far this year, potentially explaining why NZD/USD has not been able to break out like AUD/USD. Balance-of-payment dynamics looks supportive for the AUD relative to the NZD, as Australia runs a positive basic balance while New Zealand does not. Additionally, while Australian portfolio flows are very depressed, New Zealand's could suffer more downside. Mitigating these positives for AUD/NZD, the New Zealand economy is much stronger than that of Australia, and the Reserve Bank of New Zealand is in much better position to increase rates than the Reserve Bank of Australia is.1 Switzerland Chart I-10Switzerland Balance Of Payments Switzerland Balance Of Payments Switzerland Balance Of Payments The Swiss franc may be expensive relative to its purchasing power parity, and it may also be contributing to the country's strong deflationary tendencies, but it does not seem to be hampering its international competitiveness. The Swiss trade balance is at a massive 6% of GDP. Additionally, thanks to the international income generated by Switzerland's gigantic net international investment position of 127% of GDP, the country runs an incredible current account surplus of around 11% of GDP (Chart I-10). Being a nation with a steady current account surplus, Switzerland re-exports much capital abroad, generating a nearly permanent deficit in its net FDI account. However, this deficit is not enough to generate a basic balance-of-payments deficit. Instead, the BBoP still stands at 6% of GDP, creating a long-term support for the CHF. In terms of portfolio flows, Switzerland has historically run a deficit, reflecting its status as a capital exporter. Only at the height of the euro area crisis did Switzerland experience net portfolio inflows. Today, portfolio flows continue to leave the country, albeit at a slower pace than before the euro area crisis. Over the next 12 months, the CHF is likely to experience continued downside against both the euro and the USD, as the Swiss National Bank remains steadfast in its fight against domestic deflationary forces. However, from a long-term perspective, Switzerland will continue to run a balance-of-payments surplus that will support the structural upward trend in the real trade-weighted CHF. Sweden Chart I-11Sweden Balance Of Payments Sweden Balance Of Payments Sweden Balance Of Payments The Swedish trade balance recently moved into deficit territory, but the nation's current account remains in a healthy surplus of more than 4% of GDP, reflecting large amounts foreign income extracted by Sweden's thanks to its large amount of assets held abroad - a legacy of decades of current account surpluses. The net FDI balance has recently moved into positive territory, as Sweden possesses some of the strongest long-term economic fundamentals in Western Europe. Thanks to this development, the basic balance of the largest Nordic economy is at its highest level in eight years (Chart I-11), representing a long-term positive for the cheap SEK. Finally, portfolio flows into Sweden are at a neutral level. However, we expect the Riksbank to begin increasing rates early next year, putting it well ahead of its European peers. This should result in growing inflows into the country, supporting the SEK, at least against the EUR and the GBP. Norway Chart I-12Norway Balance Of Payments Norway Balance Of Payments Norway Balance Of Payments Due to the collapse in oil prices since 2014, the Norwegian trade surplus has melted from a gargantuan 15% of GDP to a more modest 5% of GDP (Chart I-12). However, falling oil prices and North-Sea production have also resulted in a collapse of FDIs into the country. Because of these developments, the Norwegian basic balance of payments has fallen into deficit for the first time in more than 20 years. This combination could explain why the NOK has been trading at its deepest discount to long-term fair value in decades. Ultimately, the constantly positive BBoP has historically been one of the key drivers of the krone. Without this support, since the Norges Bank stands among the most dovish central banks in the G10, the NOK does need a greater-than-normal discount. Norway too has historically experienced net portfolio outflows, also a consequence of its massive current account surplus. Thus, we do not read today's relatively small portfolio outflows as a positive. Instead, they simply reflect the deterioration in the current account and basic balance. Putting it all together, while balance-of-payment dynamics do explain why the NOK is trading at a historically large discount to fair value, we remain positive on this currency relative to the euro. When all is said and done, even accounting for these exceptional factors, the NOK is too cheap. Additionally, BCA does expect oil prices to move back toward US$60/bbl, which should help move the basic balance back into positive territory. Bottom Line: Balance-of-payment dynamics rarely have much impact on G10 currencies in the short run. However, in the long run, they can become paramount. Using this framework, while the USD could experience some upside in the next 12 months or so, any such upside is likely to mark the last hurrah of the bull market: the U.S. balance of payments is relatively neutral, but Europe's is currently excessively handicapped by extremely depressed portfolio flows. This latter situation is likely to be reversed in the coming years. The yen balance-of-payment dynamics will become increasingly tenuous if the BoJ continues on its current policy path. Among commodity currencies, the AUD has the best long-term profile in terms of balance-of-payment dynamics. Finally, the SNB faces a Herculean task: While it is currently keeping the CHF at bay in order to alleviate deflationary tendencies in Switzerland, the country's perennially strong balance of payment will ultimately prove too great a hurdle to overcome. The CHF could overtake the yen as the true risk-off currency of the world in future. BoE Is Stuck With Low Rates For Now In our January 13 Special Report titled, "GBP: Dismal Expectations,"2 we discussed why fears of any calamity that Brexit could bring to the British economy was overdone, and thus why buying the pound was an attractive opportunity. So far, our view has been validated, as cable has rallied by almost 8%. However, although we stand by our analysis on a cyclical horizon, a tactical selloff in the pound may be due. At the beginning of the year, the U.K. economy outperformed almost every forecast. Since then, expectations have risen along with the pound, but the British economy has shifted from star performer to disappointment (Chart I-13). For example, house price growth has collapsed to levels not seen since the euro area crisis (Chart I-14, top panel). Furthermore, the rapid rise in inflation has also caused a contraction in real disposable income comparable to that of 2012 (Chart I-14, bottom panel). Chart I-13Shift In U.K. Surprises Shift In U.K. Surprises Shift In U.K. Surprises Chart I-14Cracks In The U.K. Cracks In The U.K. Cracks In The U.K. Rate expectations have become too lofty. After the 2016 collapse in the pound, both headline and core inflation rose above the BoE's target. Consequently, rate expectations spiked, particularly after three MPC members voted for hikes. But can this rate of inflation continue? Looking at individual components of inflation, it is clear that the pound selloff was an important culprit behind the inflation surge. Thus, as the pass-through from the currency dissipates, inflation will also subside (Chart I-15). Falling inflation and weaker growth are already forcing the BoE to retreat from its relative hawkishness. Yesterday, as the "Old Lady" curtailed both its growth and wage forecast for 2017 and 2018, only two members voted for a hike. Political dynamics have also supported cable so far this year. Today, the U.K. policy uncertainty index is at par with that of the U.S. as the Trump White House continues to be in disarray, and the outlook for tax reform and/or infrastructure spending looks grim (Chart I-16). But the U.S. is not the country engaging in its most contentious and significant treaty negotiation in 50 years. Instead, the U.K. is this country, with a weakened government at its helm following its recent electoral debacle. Thus, we would expect a reversal of the currently pro-pound relative political uncertainty indexes, as Brexit negotiations heat up in the coming quarters. Chart I-15U.K. Inflation Is Peaking U.K. Inflation Is Peaking U.K. Inflation Is Peaking Chart I-16Does Trump Really Trump Brexit? Does Trump Really Trump Brexit? Does Trump Really Trump Brexit? While policy and political considerations are likely to hurt the pound this fall, for GBP/USD to correct, a fall in the euro will be needed as well. In the meantime, investors may look to continue to buy EUR/GBP. Since July 7th, we have been anticipating this cross to hit the 0.93 level. This analysis confirms this view. Bottom Line: The U.K. economy should be able to weather its exit from the European Union. This should help the pound on a cyclical horizon. However, the pound has become overbought and interest rate expectations are too elevated, as the market has forgotten that a price still has to be paid for Brexit. GBP/USD is too dependent on the EUR/USD dynamics to short cable outright right now. As such, investors may keep buying EUR/GBP for now, and look to sell GBP/USD near 1.33. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Juan Manuel Correa, Research Analyst juanc@bcaresearch.com 1 Please see Foreign Exchange Strategy and Global Alpha Sector Strategy Special Report titled, "Who Hikes Next?", dated June 30, 2017, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Special Report titled "GBP: Dismal Expectations", dated January 13, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 The U.S. has shown some signs of strength this week, however the data remains mixed: Both headline PCE and core PCE beat expectations, coming in at 1.4% and 1.5% respectively; While the headline ISM manufacturing number weakened, the Price Paid component rebounded to 62. Initial jobless claims beat expectations by 2,000; however, continuing claims underperformed; Factory orders improved on a monthly basis. While the U.S. is still in an inflation slump, we believe that inflation is close to bottoming out. The depreciation in the greenback and the rally in risk assets have greatly eased financial conditions, creating support for the economy. This should push the greenback up as the markets begin to reprice Fed hikes. Report Links: Who Hikes Next? - June 30, 2017 Look Ahead, Not Back - June 9, 2017 Capacity Explosion = Inflation Implosion - June 2, 2017 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Euro appreciation has continued. While the general tone of data remains strong, some leading indicators are showing early cracks: Unemployment, a lagging indicator, decreased to 9.1%, outperforming expectations; Headline inflation remained steady at 1.3%, however core inflation increased to 1.2%; GDP numbers came in as expected, growing at a 0.6% quarterly rate, and a 2.1% annual rate; However, German and EMU Markit Manufacturing PMIs both underperformed expectations. Momentum is on the euro's side, which traded above 1.19 on Wednesday. The euro area owes much of its economic growth to the 25% depreciation since mid-2014. While data has surprised to the upside, the ECB remains the central bank of the peripheries, where inflation has failed to emerge as strongly. Rate differentials will weigh on the euro towards the end of the year, but momentum could continue to push the euro up in the coming weeks. Report Links: Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Japanese data came in positive: Overall household spending yearly growth came in above expectations at 2.3% Japan's job-to-applicants ratio came in at 1.51. Above expectations and growing from the previous month. The unemployment rate fell to 2.8%, coming in below expectations of 3%. These two last data points are important, as they show that the Japanese labor market is getting increasingly tight. However, as evidenced by the last 2 years, inflation will not be able to rise sustainably without a depreciating yen, even if the labor market is tight. Thus, the recent selloff in USD/JPY will only incentivize authorities to remain very accommodative while other central banks are exiting maximum accommodation, reinforcing our negative cyclical view on the yen. Report Links: Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 Updating Our Intermediate Timing Models - April 28, 2017 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Data in the U.K. was mixed this week: Both Markit Manufacturing and Markit Services PMI beat expectations coming in at 55.1 and 53.8 respectively. However both consumer credit and mortgage approvals fell from the previous month and underperformed expectations. Up to yesterday the pound had gained almost 2% during the week, however following the interest rate decision by the BoE, the pound fell by roughly 1%. The reason for this fall, was that the BoE is becoming less hawkish. Not only did the number of MPC members voting for a hike decrease from 3 to 2, but the bank also lowered its forecast for growth and wages. We believe this will start a trend toward a less hawkish BoE, which will weigh on the pound on the short term. Report Links: Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Momentum is showing signs of topping out. The MACD is rolling over, and is converging with the Signal line; and the RSI is weakening from deeply overbought levels. This week, AUD has displayed broad-based weaknesses. Despite one key blotch, data relevant to Australia has been good: TD Securities Inflation increased at a 2.7% rate in July; Chinese Caixin Manufacturing PMI came out better than expected at 51.1; Building permits increased at a striking 10.9% monthly rate. They contracted at a 2.3% yearly pace, a sharp improvement over the the previous month's 18.7% contraction. However, the trade balance underperformed missed expectations by a large margin, coming in at AUD856mn, compared to the expected AUD1,800mn. The recent RBA statement highlighted that the recent appreciation in the Australian dollar "is expected to contribute to subdued price pressures", and "is weighing on the outlook for output and employment". This could add substantial pressure on the AUD in the near future. Report Links: Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 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 Even as the dollar has fallen, the kiwi has depreciated by almost 1.4% this week, as New Zealand data has come in weak: Both the ANZ Activity outlook and the ANZ business confidence came in below the previous month reading at 40.3% and 19.4 respectively. The participation rate came below expectations at 70%. Meanwhile employment also came below expectations contracting by 0.2% Month-on-Month. Overall we continue to be bearish on commodity currencies in general and the kiwi in particular. Recently, the Chinese authorities have been getting tougher on credit excesses. This could be the trigger for a risk off period in emerging markets, which wouldweigh on the NZD. That being said, we are more bearish on AUD/NZD, as the kiwi economy is on much stronger footing than the Australian one. Report Links: Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 The CAD has displayed some considerable broad-based weakness this week following weak data releases: Industrial Product Price contracted monthly by 1% in June; The Raw Material Price Index also contracted, at 3.7%; However, the Markit Manufacturing PMI saw an increase to 55.5 from 54.7. Markets have priced in a 75% probability of a hike by the end of this year by the BoC, compared to 42% for the Fed. Although we agree with the market's perception of the BoC, we disagree that the probability of the Fed hiking is this low. We therefore believe the CAD could correct further in the upcoming weeks. Report Links: Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 Exploring Risks To Our DXY View - May 26, 2017 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland has been positive: The KOF leading indicator came at 106.8, beating expectations. Real retail sales grew by 1.5% year on year, increasing from last month number and beating expectations. The SVME Purchasing Manager Index came in very strong at 60.9, beating expectations and also increasing from last month's reading. While data was positive, EUR/CHF went vertical this week, rising by more than 3%. At this point EUR/CHF is the most overbought it has been in more than 4 years, and at least a small correction seems overdue. The SNB will be satisfied with a depreciating currency, as this dramatic fall should help ease deflationary pressures in the alpine country. Report Links: Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data has been mixed in Norway: The Labor forced survey, which measures unemployment, came in at 4.3% outperforming expectations of 4.5%. The above data point was confirmed by the registered unemployment reading, which also outperformed expectations, coming in at 2.8%. However retail sales contracted by 0.6% month-on-month. Even as the dollar continues to fall, USD/NOK has stayed relatively flat this week. Curiously this has also happened amid rising oil prices. Overall, we expect USD/NOK to rally in the fall, as the Norwegian economy remains tepid, and inflation is not likely to rise above target any time soon, while investors are still underestimating the Fed's will to push interest rates higher. That being said, we are bearish on EUR/NOK, as this cross trades as a mirror image of oil, and the OPEC deal should continue to remove excess supply from the market and push prices higher. Report Links: Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 Exploring Risks To Our DXY View - May 26, 2017 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Sweden has been generating substantial inflationary pressures, and increasing economy activity is likely to support these pressures, hence the Riksbank's recent hawkishness. With China tightening policy, SEK strength could be a story of rate differentials going forward, appreciating against EUR, AUD, NZD and NOK, as the Riksbank is likely to become increasingly nervous in the face of rising inflationary pressures. However, as the market currently underprices the risk of a more hawkish Fed, the picture for USD/SEK is less clear. Report Links: Who Hikes Next? - June 30, 2017 Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Major central banks outside the U.S. have fired a warning shot across the bow of global bond markets by signaling that "emergency" levels of monetary accommodation are no longer required. Pipeline inflation pressures have yet to show up at the consumer price level outside of the U.K. Most central bankers argue that temporary factors are to blame, but longer-lasting forces could be at work. There are numerous examples of deflationary pressure driven by waves of innovation, cost cutting and changing business models. However, this is not confirmed in the productivity data. Productivity is dismally low and we do not believe it is due to mismeasurement. The Phillips curve is not dead. We expect that inflation will firm by enough to allow central banks to continue scaling back monetary stimulus. The real fed funds rate is not far from the neutral short-term rate, but it is still well below the Fed's estimate of the long-run neutral rate. Market expectations for the Fed are far too complacent; keep duration short. The failure to repeal Obamacare could actually increase the motivation of Republicans to move forward on tax cuts. Expansionary fiscal policy would make life more difficult for the FOMC, given that unemployment is on course to reach the lowest level since 2000. This would force the Fed to act more aggressively, possibly triggering a recession in 2019. The peak Fed/ECB policy divergence is not behind us, implying that recent dollar weakness will reverse. However, the next dollar upleg has been delayed. Fading market hopes for U.S. fiscal stimulus this year have not weighed on equities, in part because of a solid earnings backdrop. Global EPS growth continues to accelerate in line with the recovery in industrial production. In the U.S., results so far suggest that Q2 will see another quarter of margin expansion. Overall earnings growth should peak above our 20% target later this year. It will be tougher sledding in the equity market once profit growth peaks in the U.S. because of poor valuation. Expect to downgrade stocks in the first half of 2018. Corporate bonds are also benefiting from the robust profit backdrop. Balance sheet health continues to deteriorate, but the spark is missing for a sustained corporate bond spread widening. Feature Chart I-1Sell-Off In Global Bond Markets ##br##Triggered By Central Bank Talk Sell-Off In Global Bond Markets Triggered By Central Bank Talk Sell-Off In Global Bond Markets Triggered By Central Bank Talk Major central banks outside the U.S. fired a warning shot across the bow of global bond markets by signaling a recalibration of monetary policy at the ECB's Forum on Central Banking in late June (Chart I-1). The heads of the Bank of England (BoE), Bank of Canada (BoC) and Swedish Riksbank all took a less dovish tone, warning that the diminished threat of deflation has reduced the need for ultra-stimulative policies. The BoC quickly followed up in July with a rate hike and a warning of more to come. The central bank now expects the economy to reach full employment and hit the inflation target by mid-2018, much earlier than previously expected. The Riksbank also backed away from its easing bias at its most recent policy meeting. The ECB's shift in stance was evident even before its Forum meeting, when President Draghi gave a glowing description of the underlying strength of the Euro Area economy. The labor market is about two percentage points closer to full employment than the U.S. was just before the infamous 2013 Taper Tantrum.1 European core inflation is admittedly below target today, but so was the U.S. rate leading up to the 2013 Tantrum. We have not forgotten about Europe's structural problems or the inherent contradictions of the single currency. Banks are still laden with bad debt (although the recapitalization of Italian banks has gone well so far). Nonetheless, from a cyclical economic standpoint, solid momentum this year will allow Draghi to scale back the ECB's ultra-accommodative monetary stance by tapering its asset purchase program early in 2018. The message that "emergency" levels of monetary accommodation are no longer needed is confirmed by our Central Bank (CB) Monitors, which measure pressure on central bankers to raise or lower interest rates (Chart I-2). The Monitors became less useful when rates hit the zero bound and quantitative easing was the only game in town, but they are becoming relevant again as more policymakers consider their exit strategy. All of our CB Monitors are currently in "tighter policy required" territory except for Japan and the Eurozone (although even those are close to the zero line). The Monitors have been rising due to both their growth and underlying inflation components. Another tick higher in PMI's for the advanced economies in July underscored that the rebound in industrial production is continuing (Chart I-3). Our short-term forecasting models, which include both hard and soft data, point to stronger growth in the major countries in the second half of 2017 (Chart I-4). Chart I-2Most In The "Tighter Policy Required" Zone Most In The "Tighter Policy Required" Zone Most In The "Tighter Policy Required" Zone Chart I-3Industrial Production Recovery Is Intact Industrial Production Recovery Is Intact Industrial Production Recovery Is Intact On the inflation side, our pipeline indicators have all signaled a modest building of underlying inflation pressure over the past year (although they have softened recently in the U.S. and Eurozone; Chart I-5). In terms of the components of these indicators, rising core producer price inflation has been partly offset by slower gains in unit labor costs in some economies. Chart I-4Our Short-Term Growth Models Are Bullish Our Short-Term Growth Models Are Bullish Our Short-Term Growth Models Are Bullish Chart I-5Some Rise In Pipeline Inflation Pressure Some Rise In Pipeline Inflation Pressure Some Rise In Pipeline Inflation Pressure These pipeline pressures have yet to show up at the consumer level. Most central bankers argue that temporary special factors are to blame, but many investors are wondering if longer-lasting forces are at work. There are numerous examples of deflationary pressure driven by waves of innovation, cost cutting and changing business models. Amazon, Uber, robotics and shale oil production are just a few examples. If this is the main story, then the inability for central banks to reach their inflation targets is a "good thing" because it reflects the adaptation of game-changing new technology. There is no doubt that important strides are being made in certain areas where new technologies are clearly driving prices down. The problem is that, at the macro level, it is not showing up in the productivity data. Productivity is dismally low across the major countries and we do not believe it is simply due to mismeasurement. A Special Report from BCA's Global Investment Strategy2 service makes a convincing case that mismeasurement is not behind the low productivity figures. In fact, it appears that productivity is over-estimated in some industries. It is also important to keep in mind that technological change is nothing new. There is a vigorous debate in academic circles on whether today's new technologies are anywhere near as positive as previous ones like indoor plumbing, electricity, the internal combustion engine and the internet. We are wowed by today's new gizmos, but they are not as transformative as previous innovations. While productivity is surging in some high-profile firms, studies show that there is a long tail of low-productivity companies that drag down the average. A full discussion is beyond the scope of this report and more research needs to be done, but we are not of the view that technology and productivity preclude rising inflation. We expect that inflation will firm by enough to allow central banks to continue scaling back monetary stimulus in the coming months and quarters. Did Yellen Turn Dovish? As with other central banks, the consensus among Fed policymakers is willing to "look through" low inflation for now. Yellen's Congressional testimony did not deviate from that view, although investors interpreted her remarks as dovish. The financial press focused on her statement that "...the policy rate is not far from neutral." However, this was followed up by the statement that "...because we also anticipate that the factors that are currently holding down the neutral rate will diminish somewhat over time, additional gradual rate hikes are likely to be appropriate over the next few years to sustain the economic expansion and return inflation to our 2 percent goal." Chart I-6Bond Market Does Not Believe The Fed Bond Market Does Not Believe The Fed Bond Market Does Not Believe The Fed The Fed believes there are two neutral interest rates: short-term and long-term. Yellen argued that the actual policy rate is currently close to the short-term neutral level, which is depressed by economic headwinds. However, Yellen and others have made the case that the short-term neutral rate is trending up as headwinds diminish, and will converge with the long-term neutral rate over time. The Fed's Summary of Economic Projections reveals what the FOMC thinks is the neutral long-term real fed funds rate; the median forecast calls for a nominal fed funds rate of 2.9% at the end of 2019 and 3% in the longer run. Incorporating a 2% inflation target, we can infer that the Fed anticipates a real neutral rate of 1% in the longer run. The Fed is likely tracking the real neutral fed funds rate using an estimate created by Laubach and Williams (LW).3 Chart I-6 shows this estimate of the neutral rate, called R-star, alongside the real federal funds rate that is calculated using 12-month trailing core PCE. The resulting real fed funds rate has risen sharply during the past seven months due to both three Fed rate hikes and a decline in inflation. If the Fed lifts rates once more this year and core inflation stays put, then the real fed funds rate would end 2017 close to zero, only 42 bps below neutral. However, it's more likely that the Fed will need to see inflation rebound before it delivers another rate hike. In a scenario where core inflation rises to 1.9% and the Fed lifts rates once more, then the real fed funds rate would actually decline between now and the end of the year. The implication is that the real fed funds rate is not far from R-star, but the nominal rate will have to rise a long way before the real rate reaches the Fed's estimate of the long-term neutral rate. Investors simply don't believe Fed policymakers. According to the bond market, the real fed funds rate will not shift into positive territory until 2021 (see real forward OIS line in Chart I-6). We think this is far too complacent. U.S. Health Care Reform: RIP The speed at which short-term rates converge with the long-run neutral rate will depend importantly on the path of fiscal policy. The Republicans' failure to pass their health care legislation is leading the investors to doubt the prospect for (stimulative) tax cuts. This may be premature. Ironically, the failure to jettison Obamacare may turn out to be a blessing in disguise for President Trump and the Republican Party. According to the Congressional Budget Office, the proposed legislation would have caused 22 million fewer Americans to have health insurance in 2026 compared with the status quo. The Senate bill would have also led to substantial cuts to Medicaid relative to existing law, as well as deep cuts to insurance subsidies for many poor and middle-class families. Many of these voters came out in support of Trump last year. The failure to repeal Obamacare could actually increase the motivation of Republicans to move forward on tax cuts anyway. The chances for broad tax reform have certainly diminished, since that will be just as difficult to get passed as healthcare reform. The GOP also wanted to use the roughly $200 billion in savings from healthcare reform to fund reduced tax rates. However, tax cuts are something that all Republicans can easily agree too, and they will need to show a legislative victory ahead of next year's mid-term elections. The difficulty will be how to pay for these cuts. We expect them to be "fully funded" in the sense that there will be offsetting spending cuts, but these will be back-loaded toward the end of the 10-year budget window, whereas the tax cuts will be front-loaded. This would generate a modest amount of fiscal stimulus over the next few years. Sub-4% U.S. Unemployment Rate Followed By Recession? Chart I-7Inside The Fed's Forecasts Inside The Fed's Forecasts Inside The Fed's Forecasts Expansionary fiscal policy would make life more difficult for the FOMC, which may have already fallen behind the curve. The unemployment rate is below the Fed's estimate of the full employment level, and it will continue to erode unless productivity picks up soon. We backed out the productivity growth rate implied by the Fed's latest Summary of Economic Projections, given its assumption that real GDP growth will be roughly 2% over the next couple of years and that the unemployment rate will stabilize near the current level. This combination implies that productivity growth will accelerate from the average rate observed so far in this expansion (0.7%) to about 1%, which is consistent with monthly payrolls of 135,000 assuming real GDP growth of 2% (Chart I-7). If we instead assume that productivity does not accelerate (and real GDP growth is 2%), then payrolls must jump to 160,000 and the unemployment rate would fall below 4% next year. The implication is that the unemployment rate is likely to soon reach levels not seen since 2000, which would force the FOMC to tighten more aggressively. The Fed would hope for a soft landing as it tries to nudge the unemployment rate higher, but the more likely result is a recession in 2019. For this year, we expect the Fed to begin balance sheet runoff in the autumn, followed by a rate hike in December. The latter hinges importantly on at least a modest rise in core PCE inflation in the coming months. A rebound in oil prices would help the Fed reach its inflation goal, even though energy prices affect the headline by more than the core rate. Saudi Energy Minister Khalid al-Falih indicated at a recent press conference in St. Petersburg that no changes are presently needed to the production deal under which OPEC and non-OPEC producers pledged to remove 1.8mn b/d from the market. The Saudi energy minister's remarks leave open the possibility of deeper cuts later this year if global inventories do not draw fast enough, or for the cuts to be extended beyond March 2018 if officials are not satisfied with progress on the storage front. We still believe they are capable of meeting this goal, despite rising shale production. Chart I-8Forecast Of Oil Inventories Forecast Of Oil Inventories Forecast Of Oil Inventories Our commodity strategists expect OECD oil inventories to reach their five-year average level by year-end or early 2018 Q1 (Chart I-8). In the absence of additional cuts, the five-year average level of OECD inventories will be higher than we estimated earlier this year, indicating that our expectation for the overall inventory drawdown later this year has been trimmed. Still, our oil strategists believe the inventory drawdowns will be sufficient to push WTI above the mid-$50s by year-end. If this forecast pans out, rising oil prices will push up headline inflation and inflation expectations in the major advanced economies. The bottom line is that the backdrop has turned bond-bearish now that central bankers in the advanced economies are in the process of scaling back the easier monetary policy that followed the deflationary 2014/15 oil shock. Duration should be kept short within global fixed income portfolios. In terms of country allocation, our global fixed income strategists have downgraded the Eurozone government bond market to underweight, joining the Treasury allocation, in light of the pending ECB tapering announcement that could place more upward pressure on yields. This was offset by upgrading Japan to maximum overweight. Max Policy Divergence Has Not Been Reached Chart I-9Europe Has A Lower Neutral Rate Europe Has A Lower Neutral Rate Europe Has A Lower Neutral Rate The change in tone by central bankers outside the U.S. has weighted heavily on the U.S. dollar. The Canadian dollar and the Euro have been particularly strong. Investors have apparently decided that the peak Fed/ECB policy divergence is now behind us. We do not agree. The ECB may be tapering, but rate hikes are a long way off because there remains a substantial amount of economic slack in the Eurozone. Laubach and Williams estimate R-star in the Eurozone to be close to zero, which is 50 basis points below the U.S. neutral rate (Chart I-9). The difference is related to slower potential growth and greater unemployment. Labor market slack across the euro area as a whole is still 3.2 percentage points higher than in 2008, and 6.7 points higher outside of Germany. The current real short-term rate is about -1%. We expect U.S. R-star to rise in absolute terms and relative to the neutral rate in the Eurozone because the U.S. is further advanced in the economic expansion. As Fed rate hike expectations ratchet up in the coming months, interest rate differentials versus Europe will widen in favor of the dollar. It is the same story for the dollar/yen rate because the Bank of Japan is a long way from raising or abandoning its 10-year bond yield peg. Japanese core inflation has fallen back to zero and medium-to-long-term inflation expectations have dipped so far this year. The annual shunto wage negotiations this summer produced little in the way of salary hikes. The major exception to our "strong dollar" call is the Canadian loonie, which we expect to appreciate versus the greenback. We also like the Aussie dollar, provided that the Chinese economy continues to hold up as we expect. Stocks Get A Free Pass For Now Chart I-10Global EPS And Industrial Production Global EPS And Industrial Production Global EPS And Industrial Production Fading market hopes for U.S. fiscal stimulus have weighed on both U.S. Treasury yields and the dollar, but the equity market has taken the news in stride. Are equity investors simply in denial? We do not think so. The equity market appears to have been given a "free pass" for now because earnings have been supportive. The combination of robust earnings growth, steady real GDP growth of around 2%, and low bond yields has been bullish for stocks so far in this expansion. At the global level, EPS growth continues to accelerate in line with the recovery in industrial production, which is a good proxy for top line growth (Chart I-10). Orders and production for capital goods in the major advanced economies have been particularly strong in recent months. The global operating margin flattened off last month according to IBES data, although margins continued to firm in the U.S. and Europe (Chart I-11). The profit acceleration is widespread across these three economies in the Basic Materials and Consumer Discretionary sectors. Industrials, Energy, Health Care and Consumer Staples are also performing well in most cases. Telecom is the weak spot. Our sector profit diffusion indexes paint an upbeat picture for the near term (Chart I-12). Chart I-11Operating Margins On The Rise Operating Margins On The Rise Operating Margins On The Rise Chart I-12Earnings Diffusion Indexes Are Bullish Earnings Diffusion Indexes Are Bullish Earnings Diffusion Indexes Are Bullish In the U.S., the second quarter earnings season is off to a good start. Results so far suggest that Q2 will see another quarter of margin expansion. We believe that U.S. margins are in a secular decline, but they are in the midst of a counter-trend rally that will last for the rest of this year. Using blended results for the second quarter, trailing S&P 500 EPS growth hit 18½% on a 4-quarter moving total basis (Chart I-13). The acceleration in earnings is impressive even after excluding the Energy sector. We projected early this year that EPS growth would peak at around 20%4 by year end, but it appears that earnings will overshoot that level. Chart I-13Robust EPS Growth Even Without Energy Robust EPS Growth Even Without Energy Robust EPS Growth Even Without Energy It will be tougher sledding in the equity market once profit growth peaks in the U.S. because of poor valuation. We are expecting to scale back our overweight equity recommendation sometime in the first half of 2018, although the global rally could be extended by constructive earnings data in Europe and Japan. The earnings recovery in both economies is behind the U.S., such that peak growth will come later in 2018. There is also more room for margins to expand in Europe than in the U.S. The relative earnings cycle is one of the reasons why we continue to favor Eurozone and Japanese stocks to the U.S. in local currency terms. Japanese stocks are also cheap to the U.S. based on our top-down valuation indicator (Chart I-14). European stocks are not far from fair value relative to the U.S., after adjusting for the fact that Europe trades structurally on the cheap side. The message from our top-down valuation indicator for European stocks is confirmed when using the bottom-up information contained in the new BCA Equity Trading Strategy platform. The Special Report beginning on page 20 describes a bottom-up valuation measure that we will use in conjunction with our top-down (index-based) measures. Corporate Bonds: Kindling And Sparks Healthy EPS growth momentum is also constructive for corporate bonds, although overall balance sheet health continues to erode in the U.S. The release of the U.S. Flow of Funds data allows us to update BCA's Corporate Health Monitor (CHM) for the first quarter (Chart I-15). The level of the CHM moved slightly deeper into "deteriorating health territory." Chart I-14Top-Down Relative Equity Valuation Top-Down Relative Equity Valuation Top-Down Relative Equity Valuation Chart I-15Deteriorating Since 2015, But... Deteriorating Since 2015, But... Deteriorating Since 2015, But... The Monitor has been a reliable indicator for the trend in corporate bond spreads over the years, calling almost all major turning points in advance. However, spreads have trended tighter over the past year even as the CHM began to signal deteriorating health in early 2015. Why the divergence? The CHM is only one of three key items on our checklist to underweight corporate bonds versus Treasurys. The other two are tight Fed policy (i.e. real interest rates that are above the neutral level) and the direction of bank lending standards for C&I loans. On its own, balance sheet deterioration only provides the kindling for a spread blowout. It also requires a spark. Investors do not worry about high leverage or a profit margin squeeze, for example, until the outlook for defaults sours. The latter occurs once inflation starts to rise and the Fed actively targets slower growth via higher interest rates. Banks see trouble on the horizon and respond by tightening lending standards, thereby restricting the flow of credit to the business sector. Defaults start to ramp up, buttressing banks' bias to curtail lending in a self-reinforcing negative feedback loop. The three items on the checklist normally occurred at roughly the same time in previous cycles because a deteriorating CHM is typically a late-cycle phenomenon. But this has been a very different cycle. High stock prices and rock-bottom bond yields have encouraged the corporate sector to leverage up and repurchase stock. At the same time, the subpar, stretched-out recovery has meant that it has taken longer than usual for the economy to reach full employment. It will be some time before U.S. short-term interest rates reach restrictive territory. As for banks, they tightened lending standards a little in 2015/16 due to the collapse of energy prices, but this has since reversed. The implication is that, while corporate health has deteriorated, we do not have the spark for a sustained corporate bond spread widening. Indeed, Moody's expects that the 12-month default rate will trend lower over the next year, which is consistent with constructive trends in corporate lending standards, industrial production and job cut announcements (all good indicators for defaults). Chart I-16 presents a valuation metric that adjusts the HY OAS for 12-month trailing default losses (i.e. it is an ex-post measure). In the forecast period, we hold today's OAS constant, but the 12-month default losses are a shifting blend of historical losses and Moody's forecast. The endpoint suggests that the market is offering about 200 basis points of default-adjusted excess yield over the Treasury curve for the next 12 months. This is roughly in line with the mid-point of the historical data. In the past, a default-adjusted spread of around 200 basis points provided positive 12-month excess returns to high-yield bonds 74% of the time, with an average return of 82 basis points. It is also a positive sign for corporate bonds that the net transfer to shareholders, in the form of buybacks, dividends and M&A activity, eased in the fourth quarter 2016 and the first quarter of 2017 (Chart I-17). Ratings migration has also improved (i.e. moderating net downgrades), especially for shareholder-friendly rating action, which is a better indicator for corporate spreads. The diminished appetite to "return cash to shareholders" may not last long, but for now it supports our overweight in both investment- and speculative-grade bonds versus Treasurys. That said, excess returns are likely to be limited to the carry given little room for spread compression. Chart I-16Still Some Value In ##br##High-Yield Corporates Still Some Value In High-Yield Corporates Still Some Value In High-Yield Corporates Chart I-17Net Transfers To Shareholders ##br##Eased In Past Two Quarters Net Transfers To Shareholders Eased In Past Two Quarters Net Transfers To Shareholders Eased In Past Two Quarters Within balanced portfolios, we recommend favoring equities to high-yield at this stage of the cycle. Value is not good enough in HY relative to stocks to expect any sustained period of outperformance in the former, assuming that the bull market in risk assets continues. Investment Conclusions A key change in the global financial landscape over the past month is a signal from central banks that they see the need for policy recalibration. Policymakers view sub-target inflation as temporary, and some are concerned that low interest rates could contribute to the formation of financial market bubbles. The bond market remains skeptical, given persistent inflation undershoots and growing anecdotal evidence that new technologies are very deflationary. It would be extremely bullish for stocks if these new technologies were indeed boosting the supply side of the economy at a faster pace than the official data suggest. Robust advances in output-per-worker would allow profits to grow quickly, and would provide the economy more breathing space before hitting inflationary capacity limits (keeping the bond vigilantes at bay). We acknowledge that there are important technological breakthroughs being made, but we do not see any evidence that this is occurring on a widespread basis sufficient to "move the dial" in terms of overall productivity growth. Indeed, the stagnation of middle class personal income is consistent with a poor productivity backdrop. Chart I-18 highlights that "creative destruction" is in a long-term bear market. Chart I-18Less Creative Destruction Less Creative Destruction Less Creative Destruction That said, the equity market is benefiting from the mini-cycle in corporate profits, which are still recovering from the earnings recession in 2015/early 2016. We expect the recovery to be complete by early 2018, which will set the stage for a substantial slowdown in EPS growth next year. It won't be a disaster, absent a recession, but demanding valuations suggest that the market could struggle to make headway through next year. We expect to trim exposure sometime in the first half of 2018. To time the exit, we will watch for a roll-over in the growth rate of S&P 500 EPS on a 4-quarter moving total basis. Investors should look for a peak in industrial production growth as a warnings sign for profits. We are also watching for a contraction in excess money, which we define as M2 divided by nominal GDP. Finally, a rise in core PCE inflation to 2% would be a signal that the Fed is about to ramp up interest rates. For now, remain overweight equities relative to bonds and cash. Favor equities to high yield, but within fixed-income portfolios, overweight investment- and speculative-grade corporates versus Treasurys. We are comfortable with our pro-risk recommendations and our below-benchmark duration stance. Unfortunately, that can't be said of our bullish U.S. dollar and oil price house views. Both are controversial calls among our strategists. As for oil, supply and demand are finely balanced and our positive view hinges importantly on OPEC agreeing to more production cuts. The obvious risk is that these cuts do not materialize. The dollar call has gone against us as the latest signs of improving global growth momentum have admittedly been outside the U.S. Meanwhile, the U.S. is stuck in a political morass, which delays the prospect of fiscal stimulus. This is not to say that U.S. growth will slow. Rather, the growth acceleration may fall short of the high expectations following last November's election. We continue to believe that the market is too complacent on the pace of Fed rate hikes in the coming quarters. An upward adjustment in rate expectations should push the dollar higher on a trade-weighted basis, as outlined above. Nonetheless, this shift will require higher U.S. inflation, the timing of which is highly uncertain. We remain dollar bulls on a 12-month horizon, but we are stepping aside and calling for a trading range in the next three months. Mark McClellan Senior Vice President The Bank Credit Analyst July 27, 2017 Next Report: August 31, 2017 1 Please see Global Fixed Income Strategy Weekly Report, "Central Banks Are Now Playing Catch-Up," dated July 4, 2017, available at gfis.bcaresearch.com 2 Please see Global Investment Strategy Special Report, "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016, available at gis.bcaresearch.com 3 Kathryn Holston, Thomas Laubach, and John C. Williams "Measuring The Natural Rates Of Interest: International Trends And Determinants," Federal Reserve Bank of San Francisco, Working Paper 2016-11 (December 2016). 4 Calculated as a year-over-year growth rate of a 4-quarter moving total of S&P data. II. The BCA ETS Trading Platform Approach To Valuing Eurozone Stocks The performance of European stocks relative to the U.S. has been dismal in the post-Lehman period. However, the Eurozone economy is performing impressively, profit growth is accelerating and margins are rising. This points to a period of outperformance for Eurozone stocks, at least in local currency terms. Standard valuation measures based on index data suggest that Eurozone stocks are cheap to the U.S. Nonetheless, the European market almost always trades at a discount, due to persistent lackluster profit performance. In Part II of our series on valuation, we approach the issue from a bottom-up perspective, utilizing the powerful analytics provided by BCA's exciting new Equity Trading Strategy (ETS) platform. The ETS software allows us to compare U.S. and European companies on a head-to-head basis and rank them based on a wide range of characteristics. The bottom-up approach avoids the problems of index construction. Investors can be confident that they will make money on a 12-month horizon by taking a position when the new bottom-up indicator reaches +/-1 standard deviations over- or under-valued, although technical information should be taken on board to sharpen the timing. The +/-2 sigma level gives clear buy/sell signals irrespective of fundamental or technical factors. Valuation alone does not justify overweight Eurozone positions at the moment, although we like the market for other reasons. The bottom-up valuation indicator will not replace our top-down version that is based on index data, but rather will be considered together when evaluating relative value. Total returns in the European equity market have bounced relative to the U.S. since 2016 in both local-currency and common currency terms (Chart II-1). However, this has offset only a tiny fraction of the dismal underperformance since 2007. In local currencies, the relative EMU/U.S. total return index is still close to its lowest level since the late 1970s. Compared with the pre-Lehman peak, the U.S. total return index is more than 96% higher according to Datastream data, while the Eurozone total return index is only now getting back to the previous high-water mark when expressed in U.S. dollars (Chart II-2). Chart II-1EMU Stocks Lag Massively... EMU Stocks Lag Massively... EMU Stocks Lag Massively... Chart II-2...Due To Depressed Earnings ...Due To Depressed Earnings ...Due To Depressed Earnings The yawning return gap between the two equity markets was almost entirely due to earnings as market multiples have moved largely in sync. Earnings-per-share (EPS) generated by U.S. companies now exceed the pre-Lehman peak by about 19%. In contrast, earnings produced by their Eurozone peers are a whopping 48% below their peak (common currency). This reflects both a slower recovery in sales-per-share growth and lower profit margins. Operating margins in Europe have been on the upswing for a year, but are still depressed by pre-Lehman standards. Margin outperformance in the U.S. is not a sector weighting story; in only 2 of 10 sectors do European operating margins exceed the U.S. The return-on-equity data tell a similar story. Nonetheless, a turning point may be at hand. Chart II-3Europe Trades At A Discount Europe Trades At A Discount Europe Trades At A Discount The Eurozone economy has been performing well, especially on a per-capita basis, and forward-looking indicators suggest that growth will remain above-trend for at least the next few quarters. U.S. profit margins have also been (temporarily) rising, but the Eurozone economy has more room to grow because there is still slack in the labor market. There is also more room for margins to rise in the Eurozone corporate sector than is the case in the U.S., where the profit cycle is further advanced. Traditional measures of value based on the MSCI indexes suggest that European stocks are on the cheap side. But are they really that cheap? Based on index data, Eurozone stocks trade at a hefty discount across most of the main valuation measures (Chart II-3). This is the case even for normalized measures such as price-to-book (P/B). However, Eurozone stocks have almost always traded at a discount. There are many possible explanations as to why there is a persistent valuation gap between these two markets, including differences in accounting standards, discount rates and sector weights. The wider use of stock buybacks in the U.S. also favors American stock valuations relative to Europe. But most important are historical differences in underlying corporate fundamentals. U.S. companies on the whole were significantly more profitable even before the Great Financial Crisis (Chart II-3). U.S. companies also tend to have lower leverage and higher interest coverage. Better profitability metrics in the U.S. are not solely an artifact of sector weighting either. RoE and operating margins are lower in Europe even applying U.S. sector weights to the European market.1 Why corporate Europe has been a perennial profit under-achiever is beyond the scope of this paper. U.S. companies reaped most of the benefit from productivity gains over the past 25 years, with the result that the capital share of income soared while the labor share collapsed. European companies were less successful in squeezing down labor costs. Measuring Value In the first part of our two-part Special Report on valuation, published in July 2016, we took a top-down approach to determine whether Eurozone stocks are cheap versus the U.S. after adjusting for different sector weights and persistent differences in the underlying profit fundamentals. A regression approach that factored in various profitability measures performed reasonably well, but the top-down "mechanical" approach that relied on a 5-year moving average provided the most profitable buy/sell signals historically. We approach the issue from a bottom-up perspective in Part II of our series, utilizing the powerful analytics provided by BCA's exciting new Equity Trading Strategy (ETS) platform. The software allows us to compare U.S. and European companies on a head-to-head basis and rank them based on a wide range of characteristics. The bottom-up approach avoids the problems of index construction when trying to gauge valuation across countries. The web-based platform uses over 24 quantitative factors to rank approximately 10,000 individual stocks in 23 countries, allowing clients to find stocks with winning characteristics at the global level. Users can rank and score individual equities to support a broad set of investment strategies and apply macro and sector views to single-name investments. The ETS approach has an impressive track record. Historically, the top-decile of stocks ranked using the "BCA Score" methodology have outperformed stocks in the bottom decile by over 25% a year.2 The BCA Score includes all 24 factors when ranking stocks, but we are interested in developing a valuation metric that provides valued added on its own and is at least as good as the top-down index-based measure developed in Part I. The five valuation measures in the ETS database are trailing P/E, forward P/E, price-to-book, price-to-sales and price-to-cash flow. We combine all of the Eurozone and U.S. companies that have total assets of greater than $1 billion into one dataset. The ETS platform then ranks the stocks from best to worst on a daily basis (i.e. cheapest to most expensive), using an equally-weighted average of the five valuation measures. The average score for U.S. stocks is subtracted from the average score for European stocks, and then divided by the standard deviation of the series. This provides a valuation metric that fluctuates roughly between +/- 2 standard deviations. Chart II-4 presents the resulting bottom-up indicator, along with our previously-published top-down valuation measure. A high reading indicates that European stocks are cheap to the U.S., while it is the opposite for low readings. Chart II-4Eurozone Equity Relative Valuation Indicators Eurozone Equity Relative Valuation Indicators Eurozone Equity Relative Valuation Indicators The underlying bottom-up data extend back to 2000. However, the bursting of the tech bubble in the early 2000's causes major shifts in relative valuation among sectors and between the U.S. and Eurozone that skew the indicator when constructed using the entire data set. We obtain a cleaner indicator when using only the data from 2005. As with any valuation indicator, it is only useful when it reaches extremes. We calculated the historical track record for a trading rule that is based on critical levels of over- and under-valuation. For example, we calculated the (local currency) excess returns over 3, 6, 12 and 24-month horizon generated by (1) overweighting European stocks when that market was one and two standard deviations cheap versus the U.S. market, and (2) overweighting the U.S. when the European market was one and two standard deviations expensive (Table II-1). Table II-1Value Indicator: Trading Rule Returns And Batting Average August 2017 August 2017 The trading rule returns were best when the indicator reached two standard deviations cheap or expensive, providing average returns of almost 11 percent over 12 months. The trading rule returns when the indicator reached +/-1 standard deviation were not as good, but still more than 3% on 12- and 24-month horizons. Table II-1 also presents the trading rule's batting average. That is, the number of positive excess returns generated by the trading rule as a percent of the total number of signals. The batting average ranged from 50% on a 3-month horizon to 68% over 24 months when buy/sell signals are triggered at +/- 1 standard deviation. The batting average is much higher (80-100%) using +/- 2 standard deviations as a trigger point, although there were only five months over the entire sample when the indicator reached this level. The charts and tables in the Appendix present the results of the same analysis at the sector level. The results are equally as good as the aggregate valuation indicator, with a couple of exceptions. European stocks are cheap to the U.S. in the Energy, Financials, and Utilities sectors, while U.S. stocks offer better value in Consumer Discretionary, Consumer Staples, Health Care, Industrials and Technology. Materials, Real Estate, and Telecommunications are close to equally valued. Sharpening The Buy/Sell Signals We then augmented the valuation analysis by adding information on company fundamentals, such as EPS growth and profit margins among others. The ETS software ranked the companies after equally-weighting the valuation and fundamental factors. However, this approach yielded poor results in terms of the trading rule. This is because, for example, when European stocks reach undervalued levels relative to the U.S., it is usually because the European earnings fundamentals have underperformed those of the U.S. companies. Thus, favorable value is offset by poor fundamentals, muddying the message provided by valuation alone. In contrast, adding some information from the technical factors in the ETS model does add value, at least when using +/-1 standard deviations as the trigger point for trades (Chart II-5). Excess returns to the trading rule rise significantly when the medium-term momentum and long-term mean reversion factors are included in the valuation indicator (Table II-2). The batting average also improves. Chart II-5Indicators: Value And Value With Technical Information Indicators: Value And Value With Technical Information Indicators: Value And Value With Technical Information Table II-2Value And Technical Indicator: Trading Rule Returns And Batting Average August 2017 August 2017 Adding technical information does not improve the trading rule performance when +/-2 sigma is used as the trigger point. Investment Conclusions Our new ETS platform provides investors with a unique way of picking stocks by combining top-down macro themes with company-specific information. It also allows us to develop valuation tools that avoid some of the pitfalls of index data by comparing stocks on a head-to-head basis. Historical analysis using a trading rule demonstrates that the new bottom-up valuation indicator provides real value to investors. We would normally evaluate its track record using stretching analysis, where we use only the historical information available at each point in time when determining relative value. However, the relatively short history of the available data precludes this test because we need at least a few cycles to best gauge the underlying volatility in the data. Still, investors can be fairly confident that they will make money on a 12-month horizon by taking a position when the bottom-up indicator reaches +/-1 sigma over- or under-valued, although technical information should be taken on board to sharpen the timing. The +/-2 sigma level gives clear buy/sell signals irrespective of the fundamental or technical factors. The bottom-up valuation indicator will not replace our top-down version that is based on index data, but rather will be considered together when evaluating relative value. At the moment, the top-down version proposes that European stocks are somewhat cheap to the U.S., while the bottom-up indicator points to slight overvaluation. Considering the two together suggests that valuation is close enough to fair value that investors cannot make the decision on value alone. Valuation indicators need to be near extremes to be informative. Our global equity strategists recommend overweighting Eurozone stocks versus the U.S. at the moment, although not because of valuation. Rather, the Eurozone economy and corporate earnings have more room to grow because of lingering labor market slack. This also means that the ECB can keep rates glued to the zero bound for at least the next 18 months while the Fed hikes, which will place upward pressure on the dollar and downward pressure on the euro. Mark McClellan Senior Vice President The Bank Credit Analyst Appendix: Trading Rule Returns By Sector Chart II-6, Chart II-7, Chart II-8, Chart II-9, Chart II-10, Chart II-11, Chart II-12, Chart II-13, Chart II-14, Chart II-15, Chart II-16. Chart II-6Consumer Discretionary Consumer Discretionary Consumer Discretionary Chart II-7Consumer Staples Consumer Staples Consumer Staples Chart II-8Energy Energy Energy Chart II-9Financials Financials Financials Chart II-10Health Care Health Care Health Care Chart II-11Industrials Industrials Industrials Chart II-12Materials Materials Materials Chart II-13Real Estate Real Estate Real Estate Chart II-14Utilities Utilities Utilities Chart II-15Technology Technology Technology Chart II-16Telecommunication Telecommunication Telecommunication 1 Please see The Bank Credit Analyst Special Report, "Are Eurozone Stocks Really That Cheap?" July 2016, available at bca.bcaresearch.com. 2 Please see Equity Trading Strategy Special Report, "Introducing ETS: A Top Down Approach to Bottom-Up Stock Picking," December 2, 2015, available at ets.bcaresearch.com. III. Indicators And Reference Charts Stocks continue to outperform bonds against a constructive backdrop of improving global economic prospects and accelerating EPS growth, while low inflation is expected to keep central banks from tightening quickly. Our main equity and asset allocation indicators remain bullish for risk, with a few exceptions. Our new Revealed Preference Indicator (RPI) jumped back to a 100% equity weighting in July. We introduced the RPI in last month's Special Report. Quite simply, it combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. Our Willingness-to-Pay (WTP) indicators are also bullish on stocks for the U.S., Europe and Japan. These indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Investors often say they are bullish but remain conservative in their asset allocation. The U.S. WTP remains bullish, but has topped out, suggesting that flows into the U.S. market are beginning to moderate. In contrast, the WTP indicators for both the Eurozone and Japan are rising from a low level. This suggests that a rotation into these equity markets is underway, although it has not yet shown up in terms of equity market outperformance versus the U.S. On the negative side, our Monetary Indicator last month fell a little further below the zero line and our composite Technical Indicator appears to be rolling over; the latter generates a 'sell' signal when it drops below its 9-month moving average. Value is stretched, but our Valuation Indicator has not yet reached the +1 standard deviation level that indicates clear over-valuation. As highlighted in the Overview section, the U.S. and global earnings backdrop continues to support equity markets. Forward earnings estimates are in a steep uptrend, and the recent surge in the net revisions ratio and the earnings surprise index suggests that EPS growth will remain impressive for the remainder of the year. Bond valuation is largely unchanged from last month, sitting very close to fair value. We still believe that fair value is rising as economic headwinds fade. However, much depends on our forecast that core inflation in the major countries will grind higher in the coming months. Central banks stand ready to "remove the punchbowl" if they get the green light from inflation. The dollar's downdraft in July reduced some of its overvaluation based on purchasing power parity measures. The dollar appears less overvalued based on other measures. Our composite Technical Indicator has fallen hard, but has not reached oversold levels. This suggests that the dollar has more downside before it finds a bottom. EQUITIES: Chart III-1U.S. Equity Indicators U.S. Equity Indicators U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-6U.S. Earnings U.S. Earnings U.S. Earnings Chart III-7Global Stock Market And Earnings: ##br##Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: ##br##Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations U.S. Treasurys and Valuations U.S. Treasurys and Valuations Chart III-10U.S. Treasury Indicators U.S. Treasury Indicators U.S. Treasury Indicators Chart III-11Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart III-30U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-31U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-32U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-33U.S. Consumption U.S. Consumption U.S. Consumption Chart III-34U.S. Housing U.S. Housing U.S. Housing Chart III-35U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China

Highlights The Fed is behind the curve in raising rates, as is the Bank of Canada, the Reserve Bank of Australia, the Reserve Bank of New Zealand, and the Swedish Riksbank. In contrast, the Bank of Japan, the ECB, and the Swiss National Bank have little need to tighten monetary policy. Accordingly, investors should favor USD, CAD, SEK, NZD, and to a lesser extent, AUD. EUR, CHF, and JPY will weaken. GBP will trade sideways. Short-term momentum could push EUR/USD to 1.18, but the euro will ultimately reach parity against the dollar next year, as the Fed is forced to accelerate the pace of rate hikes. Stay structurally long DXY. Go long SEK/CHF. We are closing our longstanding overweight positions in Australian and New Zealand government bonds for a handsome profit. Remain overweight global equities for now, but be prepared to turn bearish in the second half of 2018. Feature The Fed: It's Time To Get A Bit More Hawkish In our December 2015 report "The Fed Makes An Unforced Error," we made the case that the Federal Reserve would regret its decision to tighten monetary policy.1 Subsequent events validated this view: U.S. growth sagged in the first half of 2016, leading to a sharp flattening in the yield curve. It would be another 12 months before the Fed raised rates again. As bond prices and the economic data evolved over the course of 2016, our recommendations changed accordingly. On July 5th, we published a note entitled "The End Of The 35-Year Bond Bull Market" arguing that it was time to take profits on long duration positions.2 As luck would have it, this was the exact same date that the 10-year Treasury yield hit a record closing low of 1.37%. Fast forward to the present and investors are once again debating the next steps that central banks are likely to take. However, unlike in 2015, a strong case can be made that the Fed is now behind the curve in raising rates, rather than ahead of it. There are three reasons for this: There is less slack now than in 2015. The unemployment rate stands at 4.4%, down from 5% in December 2015. The broader U-6 unemployment rate has fallen even more, from 9.9% to 8.6%. Other measures of labor market slack are also closing in on their past business-cycle lows (Table 1). Table 1Comparing Current Labor Market Slack With Past Cycles Are Central Banks Behind The Curve Or Ahead Of It? Are Central Banks Behind The Curve Or Ahead Of It? The neutral interest rate has likely risen somewhat over the past 18 months (Chart 1). Household debt has continued to decline as a share of disposable income. The share of national income going to labor has increased. Wage growth among lower-income workers who tend to spend most of their paychecks has accelerated. All this should give consumers the wherewithal to spend more, warranting higher interest rates. Bank balance sheets have also continued to improve, as evidenced by the recent stress test results. In addition, fiscal policy has eased modestly and could ease even more if Congress is able to pass legislation cutting taxes later this year or in early 2018. Financial conditions have eased significantly since the start of the year, which should boost growth in the second half of this year (Chart 2). This is in sharp contrast to 2015, a year when financial conditions tightened sharply. Easier financial conditions are boosting credit growth. The annualized 3-month change in bank credit has accelerated from 1.1% in April to 4.2% at present. (Chart 3). Chart 1Households Have The Wherewithal To Spend More Households Have The Wherewithal To Spend More Households Have The Wherewithal To Spend More Chart 2Financial Conditions Have Eased Financial Conditions Have Eased Financial Conditions Have Eased Chart 3Credit Growth Has Picked Up Credit Growth Has Picked Up Credit Growth Has Picked Up The prospect of stronger growth over the next few quarters implies that the unemployment rate is likely to fall below 4% early next year, possibly breaking through the 2000 low of 3.8%. If that were to happen, the unemployment rate would end up being nearly a full percentage point below the Fed's estimate of NAIRU. It is possible, of course, that the true value of NAIRU is lower than official estimates suggest. Older workers change jobs less frequently, and so an aging workforce tends to produce less frictional unemployment. The internet has also improved the ability of companies to fill vacancies with suitable workers. On the flipside, declining geographical mobility and falling demand for low-skilled labor may have raised structural unemployment. On balance, we are skeptical that the current estimate of NAIRU of 4.7% - already one percentage point below its post-1960 average (Chart 4) - is significantly overstated. A tighter U.S. labor market will put upward pressure on wages. While recent wage data has been on the soft side, our wage tracker is still growing twice as fast as in 2010 (Chart 5). Indeed, for all the talk about how wage growth is "inexplicably" slow, real wages have been rising more quickly than productivity for three straight years now - the longest stretch since the late 1990s (Chart 6). Chart 4NAIRU Is Low By Historic Standards NAIRU Is Low By Historic Standards NAIRU Is Low By Historic Standards Chart 5A Stronger Labor Market Will Lead To Faster Wage Growth A Stronger Labor Market Will Lead To Faster Wage Growth A Stronger Labor Market Will Lead To Faster Wage Growth Chart 6Real Wages Now Increasing Faster Than Productivity Real Wages Now Increasing Faster Than Productivity Real Wages Now Increasing Faster Than Productivity Inflation: A Lagging Indicator When will accelerating wage growth translate into sharply higher price inflation? Probably not this year. Historically, inflation has been the mother-of-all lagging indicators. Core inflation peaked at 2.5% in August 2008, eight months after the start of the recession. In fact, core inflation has topped out in every single business cycle over the past 40 years only after the expansion has ended and the recession begun (Chart 7). Likewise, core inflation typically bottoms several years after the economic recovery is underway. This suggests that inflation could stay subdued for the next 12 months as the labor market slowly overheats, before moving higher in the second half of 2018. Chart 7Inflation Is A Lagging Indicator Are Central Banks Behind The Curve Or Ahead Of It? Are Central Banks Behind The Curve Or Ahead Of It? If the Fed drags its feet in raising interest rates, it will be difficult to achieve a soft landing. Stabilizing the economy is akin to landing a plane: You don't just need to know the speed at which you have to hit the runway, you also have to time your descent in order to touch the ground at precisely the right speed. Even if the Fed knew where the neutral interest rate stood (which it doesn't), tightening monetary policy too late could end up pushing the unemployment rate to such a low level that it has nowhere to go but up. And as we have shown before, once the unemployment rate starts rising, it generally keeps rising, owing to the presence of numerous negative feedback loops.3 The Fed has arguably already fallen into the trap of waiting too long. If so, gradual rate hikes this year will give way to more aggressive hikes late next year, setting the stage for a recession in 2019. The Bank Of Canada Turns Hawkish On the other side of the 45th parallel, the Bank of Canada raised rates last week and signaled that further hikes lie in store. The BoC revised up its GDP growth forecasts for 2017 and 2018. It also indicated that the output gap would close later this year, rather than next year as it had earlier projected. The Bank of Canada's newfound optimism was bolstered by the most recent Business Outlook Survey, which pointed to accelerating growth, dwindling spare industrial capacity, and an increasingly tight labor market (Chart 8). The moose in the living room is the Canadian housing market (Chart 9). Central bankers are generally reluctant to use the blunt tool of tighter monetary policy to target excessive property prices. However, when stricter macroprudential regulations fail to do the job, the standard prescription is to tighten monetary policy slowly but early. The Bank of Canada has done the former but not the latter. Consequently, as my colleague Jonathan LaBerge argued in last week's Special Report, the coming housing bust is likely to be a nasty affair.4 This will be the price the Bank of Canada pays for being behind the curve. Chart 8Canadian Growth Picture Is Upbeat Are Central Banks Behind The Curve Or Ahead Of It? Are Central Banks Behind The Curve Or Ahead Of It? Chart 9Housing Bubbles Abound Housing Bubbles Abound Housing Bubbles Abound For now, we remain long the Canadian dollar in our currency recommendations. We are expressing this view by being long CAD/EUR, a trade that has gained 3.5% in the nine weeks since we initiated it. We also recommend being underweight Canadian government bonds within a global fixed-income portfolio. It is important to stress, however, that these are 12-month views. Most Canadian mortgages are floating rate. Higher borrowing costs will likely trigger a housing bust late next year or in 2019, forcing the Bank of Canada to slow or even reverse the pace of rate hikes. The RBA And RBNZ ... Behind The Curve Too Australia and New Zealand have also been grappling with dangerously overvalued housing markets, and just as in Canada, the RBA and RBNZ have been behind the curve in responding to the brewing excesses. That is starting to change. The Reserve Bank of Australia struck a hawkish tone in the July 4 meeting minutes released this week, sending the Aussie dollar to a 26-month high against the greenback. The RBA highlighted the improvement in business conditions and a tightening labor market. It also indicated that the "neutral cash rate" was 3.5%, two points higher than the rate of 1.5%. Australia's terms of trade have been recovering of late and this should support the economy as well as the Aussie dollar (Chart 10). The RBNZ is even further behind the curve than the RBA (Chart 11). Nominal GDP is growing at over 6% and retail sales are expanding at nearly 8%. Population growth has risen sharply in recent years due to increased immigration, leading to greater demand for housing. The government has increased infrastructure spending and cut taxes. The unemployment rate has fallen back to an 8-year low of 4.9%, while the terms of trade is approaching record-high levels. Chart 10RBA Behind The Curve... RBA Behind The Curve... RBA Behind The Curve... Chart 11... And RBNZ Too? ... And RBNZ Too? ... And RBNZ Too? With all this in mind, we are closing our longstanding overweight positions in Australian and New Zealand government bonds for gains of 59.5% and 74.2%, respectively.5 Riksbank: End Of NIRP? The Swedish repo rate stands at -0.5%, despite the fact that the output gap has moved into positive territory (Chart 12). Inflation is still slightly below target, but is moving higher. The Riksbank is taking notice of the changing economic environment. The central bank backed away from its easing bias at its most recent policy meeting. The facts on the ground support this decision. Sweden's GDP is now 0.7% above potential and the economy continues to strengthen. The Riksbank's resource utilization indicator points to a sharp acceleration in Swedish inflation in the coming quarters. Nonfinancial private credit has reached 237% of GDP, up from 106% in 2000. If the Riksbank falls too far behind the curve, it will be forced to jack up rates very aggressively down the road, reviving the specter of the debt crisis of the early 1990s. The ECB, SNB, And BoJ: Take It Easy Whereas a strong case can be made that the central banks discussed above are behind the curve in normalizing monetary policy, the same cannot be said for the ECB, Swiss National Bank, or Bank of Japan. Labor market slack across the euro area as a whole is still 3.2 percentage points higher than in 2008 and 6.7 points higher outside of Germany (Chart 13). Moreover, as we discussed two weeks ago, the neutral rate in the euro area remains very depressed.6 Thus, even if the euro area economy were close to full employment, the ECB would still not have much scope to raise rates. Chart 12NIRP In Sweden: R.I.P. NIRP In Sweden: R.I.P. NIRP In Sweden: R.I.P. Chart 13Euro Area: Labor Market Slack Still High Outside Of Germany Euro Area: Labor Market Slack Still High Outside Of Germany Euro Area: Labor Market Slack Still High Outside Of Germany In this light, investors have gotten too optimistic about the ability of the ECB to tighten monetary policy. While the ECB will further taper asset purchases as early as this autumn, sustained rate hikes are still a few years away. Mario Draghi explicitly said during his press conference yesterday that "the last thing that the governing council may want is actually an unwanted tightening of the financing conditions." This is in sharp contrast to the Fed, which is trying to tighten financial conditions by raising rates. Swiss monetary conditions are far from accommodative, despite a policy rate that remains buried in negative territory (Chart 14). Core inflation is close to zero and wage growth is anemic. An overvalued currency has offset the benefits from lower interest rates. Given the SNB's policy of intervening in the currency markets to keep EUR/CHF within a reasonably tight range, the recent appreciation of the euro will further add to the deflationary pressures weighing on the Swiss economy. Investors should position for a weaker franc (and euro) in the months ahead. Go long SEK/CHF (Chart 15). Chart 14The Swiss Economy Still Needs Low Rates The Swiss Economy Still Needs Low Rates The Swiss Economy Still Needs Low Rates Chart 15Long SEK/CHF Long SEK/CHF Long SEK/CHF Similar to the ECB and the SNB, the Bank of Japan is in no position to tighten monetary policy. Core inflation has fallen back to zero and medium-to-long-term inflation expectations have dipped so far this year (Chart 16). The annual shunto wage negotiations this summer produced little in the way of salary hikes. And even if inflation were to rise, the government would likely want to tighten fiscal policy before contemplating removing the monetary punch bowl. The Bank Of England: A Tough Call If one didn't know what transpired last June, the case for tighter monetary policy in the U.K. would be fairly straightforward. The unemployment rate is at a 9-year low and inflation is well above target. The trade-weighted pound has weakened by 21% since November 2015, which in most cases, would translate into stronger growth in the years ahead. Reflecting these points, our Central Bank Monitors show that the U.K. is more in need of tighter money than any other major developed economy (Chart 17). Chart 16BoJ: In No Position To Tighten BoJ: In No Position To Tighten BoJ: In No Position To Tighten Chart 17The Message From Our Central Bank Monitors The Message From Our Central Bank Monitors The Message From Our Central Bank Monitors Brexit negotiations are likely to cast a pall over the economy, however. The EU will be forced to take a tough line with the U.K., for fear that the Brexit vote could prompt other countries to follow's Britain's lead. BCA's geopolitical strategists ultimately expect a "hard Brexit" to be averted, but things may need to be brought to the precipice before that happens. The pound is cheap and so we do not expect it to weaken significantly from current levels. Nevertheless, the upside for both sterling and gilt yields will remain constrained until political uncertainty abates. Investment Conclusions As a rule of thumb, investors should favor currencies in economies whose central banks are behind the curve. Such central banks are likely to find themselves in a position where they have to scramble to tighten monetary policy. We noted on July 7th that short-term momentum favors the euro and that we would not be surprised if EUR/USD reaches 1.18 over the coming weeks. Looking further ahead, the appreciation of the euro in the first half of this year will weigh on growth in the remainder of 2017 and into early 2018. This will force the ECB to cool its heels. In contrast, U.S. growth should accelerate. Against the backdrop of diminished spare capacity, this will prompt the Fed to turn more hawkish. We expect EUR/USD to fall to 1.05 by year-end, and reach parity next year as the Fed ramps up the pace of rate hikes. The market is betting that the Fed will deliver fewer rate hikes than implied by the 'dots'. Our hunch is that the Fed will deliver more hikes than what its forecast suggests, especially starting early next year when inflation is liable to accelerate. Bullish sentiment towards the dollar has collapsed. Investors should turn contrarian and position for a stronger greenback over the next 12 months. In addition to the dollar, we like the Swedish krona, Canadian dollar, and New Zealand dollar. The Aussie dollar should also perform reasonably well, provided that the Chinese economy continues to hold up, as we expect it will. The Japanese yen remains our least favorite currency. Despite the dollar selloff, USD/JPY has managed to gain 3% since mid-April. As the Fed and a number of other central banks raise rates, the spread in yields between foreign government bonds and JGBs will widen. This will push down the yen, helping Japanese stocks in the process. As far as overall risk sentiment is concerned, another rule of thumb says that stocks rarely fall on a sustained basis outside of recessions (Chart 18). We do not expect a recession in the U.S. or elsewhere until 2019. This implies that investors should maintain an overweight position in global equities for now, favoring cyclical sectors over defensive ones. Chart 18Stocks Rarely Fall On A Sustained Basis Outside Of Recessions Stocks Rarely Fall On A Sustained Basis Outside Of Recessions Stocks Rarely Fall On A Sustained Basis Outside Of Recessions Peter Berezin, Global Chief Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "The Fed Makes An Unforced Error," dated December 18, 2015, available at gis.bcaresearch.com. 2 Please see Global Investment Strategy Special Report, "End Of The 35-Year Bond Bull Market," dated July 5, 2016, available at gis.bcaresearch.com 3 Please see Global Investment Strategy Weekly Report, "When Doves Cry," dated June 9, 2017, available at gis.bcaresearch.com. 4 Please see Global Investment Strategy Special Report, "Canada: A (Probably) Happy Moment In An Otherwise Sad Story," dated July 14, 2017, available at gis.bcaresearch.com. 5 Calculated as the total excess return on the 10-year bond index relative to global government benchmark since inception in 2009, foreign-currency hedged since 2014. The 10-year yield for New Zealand government bonds has dropped from 4.28% at the time of inception to 2.94% today. The 10-year yield for Australian government bonds has fallen from 4.10% to 2.74% over this period. 6 Please see Global Investment Strategy Weekly Report, "Draghi's Dilemma," dated July 7, 2017, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights DM Rates Strategy: Many central banks are responding to the strong global economic backdrop by signaling not only a shift in the bias of monetary policy, but actual changes in interest rates or asset purchases. We continue to recommend a below-benchmark overall portfolio stance, but with more diverse views on country allocation: underweight the U.S., Euro Area, & Canada; maximum overweight on Japan; and neutral on the U.K. and Australia. Expect steeper yield curves in the U.S., Euro Area and U.K., and continued flattening in Canada. U.S. Corporate Bond Liquidity: There are few signs of diminished liquidity in U.S. corporate bond markets, despite the sharply reduced inventories of primary dealers. ETFs and institutional investors have picked up the slack from the dealers, as has electronic trading directly between market participants. Feature Chart of the Week2013 Revisited 2013 Revisited 2013 Revisited Developed Market (DM) policymakers continue to push towards a less accommodative monetary stance. Last week, the Bank of Canada (BoC) became the second central bank to hike rates this year, following the Fed's earlier tightenings. The European Central Bank (ECB) continues to signal a move to reduce the pace of its asset purchases, likely to be announced at the September policy meeting. A very public debate has opened up among the members of the Bank of England (BoE) policy committee against the stagflationary backdrop of high inflation and cooling growth. This current backdrop is reminiscent of the 2013 synchronized global economic upturn that also put pressure on policymakers to become less accommodative according to our Central Bank Monitors (Chart of the Week). That year was terrible for government bonds, but spread product held in well given the solid growth backdrop. A big difference now is that there is greater evidence of diminished economic slack (lower unemployment rates, higher capacity utilization) than in 2013, so the underlying inflation pressures should be greater. Realized inflation rates remain subdued in most countries (excluding the U.K.), but central bankers are attributing that to temporary factors that should soon fade. That forecast may prove to be wrong, which risks a potential policy mistake if interest rates move up too much or too fast. For now, however, central banks are in charge and bond investors should position accordingly by limiting duration exposure and overweighting growth-sensitive assets like corporate bonds versus sovereign debt. A Country-By-Country Summary Of Our Interest Rate Views With central banks now in the process of adjusting policy settings to varying degrees, financial markets are starting to show a greater level of diversification than in previous years. This can be seen in the moves in bond yields, equity markets and currencies since the speech by ECB President Mario Draghi on June 27 that ignited the latest bond sell-off (Chart 2). The largest yield moves have occurred in the Euro Area, U.K., Canada and Australia, which have also coincided with currency strength and equity market underperformance in those countries. As the markets now try to sort out the growing divergences between monetary policies, this has opened up opportunities for diversification of duration exposures, country allocation and yield curve strategies. This week, we present a brief summary of our individual country recommendations for the remainder of the year. United States: underweight duration, underweight country allocation, steeper yield curve, long inflation protection The Fed remains on track for a move to begin reducing its balance sheet at the September FOMC meeting, with another rate hike expected in December. The inflation data of late has started to raise concern among some FOMC members about how many more interest rate increases will be necessary for this tightening cycle. We expect U.S. growth to show solid improvement over the latter half of 2017, and for this current downdraft in realized inflation to soon bottom out led by tightening labor markets and the lagged impact of this year's decline in the U.S. dollar. Treasury yields will continue to grind higher in the months ahead, led more by rising inflation expectations that will bear-steepen the yield curve. (Chart 3) Chart 2Market Moves Since Draghi's Portugal Speech Global Interest Rate Strategy For The Remainder Of 2017 Global Interest Rate Strategy For The Remainder Of 2017 Chart 3U.S. Rates Strategy Summary U.S. Rates Strategy Summary U.S. Rates Strategy Summary Germany: underweight duration, underweight country allocation, steeper yield curve, long inflation protection France: underweight duration, underweight country allocation, steeper yield curve, long inflation protection Italy: underweight duration, underweight country allocation (versus Spain), steeper yield curve The ECB is clearly signaling that a taper of its asset purchase program will begin in 2018. The Wall Street Journal reported last week that Mario Draghi will speak at the upcoming Fed Jackson Hole conference in late August.1 Similar to his speech at the ECB Forum in late June, this will likely be another opportunity for Draghi to prepare financial markets and other central bankers for the ECB's policy shift. We expect an announcement of a "Fed-like" tapering of bond purchases that will begin in January and end sometime in the fourth quarter of 2018. A rate hike is still some time away, most likely in the first half of 2019 at the earliest. The ECB will want to see more signs of lower unemployment and sustainable higher core Euro Area inflation before contemplating higher short-term interest rates - especially given the likely positive impact on the euro from such a move that would risk an unwanted tightening of financial conditions. There is far more risk in longer-dated bond yields to reprice via higher term premia and/or inflation expectations, thus we are recommending a bearish stance not only on European duration and country allocation, but also a bias toward steeper yield curves (Chart 4 & Chart 5). Tapering will also put upward pressure on Peripheral European yields and spreads, particularly in Italy, as risk premiums normalize away from the tight levels seen during the ECB asset purchase program. We do not anticipate a rout in Italian debt given the current improvements in the domestic economy and the positive moves seen in consolidating and recapitalizing the troubled Italian banking sector. However, we do see continued underperformance of Italian debt versus Spanish sovereigns, thus we are maintaining an overweight stance on Spain versus Italy in our model bond portfolio (Chart 6). Chart 4Germany Rates Strategy Summary Germany Rates Strategy Summary Germany Rates Strategy Summary Chart 5France Rates Strategy Summary France Rates Strategy Summary France Rates Strategy Summary Chart 6Italy & Spain Strategy Summary Italy & Spain Strategy Summary Italy & Spain Strategy Summary U.K.: underweight duration, neutral country allocation, neutral yield curve We have been maintaining a neutral allocation to U.K. Gilts, but with an underweight duration exposure and a curve steepening bias (Chart 7). The growing rift among the members of the BoE Monetary Policy Committee does suggest that there could be more two-way risk in U.K. interest rates than at any time seen since last year's Brexit vote. The BoE responded to that political surprise with rate cuts and a new round of asset purchases, even though the U.K. economy was operating at full employment at the time and inflation pressures were rising. Now, the chickens have come home to roost for the BoE, with inflation remaining stubbornly high despite signs of slowing growth (Chart 8). With real wage growth slowing substantially and household saving rates at very low levels, the risk of a consumer spending slowdown - that the BoE was flagging earlier in the year - is increasing. Chart 7U.K. Rates Strategy Summary U.K. Rates Strategy Summary U.K. Rates Strategy Summary Chart 8Stagflation In The U.K. Stagflation In The U.K. Stagflation In The U.K. Given the ongoing uncertainties from the upcoming Brexit negotiations that will likely continue to weight on business confidence and investment spending, and with consumption likely to continue losing steam, we see little case for the BoE to seriously consider a rate hike before year-end. We are only recommending a neutral stance on Gilts, though, as realized inflation continues to run well above the BoE's target, supported by the stubbornly soft British pound. We continue to recommend a steepening bias on the Gilt curve until there is more decisive evidence that U.K. inflation is rolling over. Japan: overweight duration, maximum overweight country allocation, neutral yield curve and neutral inflation protection We continue to recommend a maximum overweight on Japanese government bonds (JGBs). JGBs are a low-beta market with the BoJ still targeting a 0% level on the benchmark 10-year yield, even as other global bond markets sell off. The BoJ has been particularly aggressive in capping any rise in JGB yields of late, offering to buy 10-year bonds in unlimited size and also increasing its purchases at shorter maturities (Chart 9). With Japanese inflation still struggling to stay in positive territory, even with the economy estimated to be operating at full employment, the BoJ will do the only thing it can do to put a floor under inflation - keep JGB yields at low levels to trigger a new wave of yen weakness and, hopefully, some imported inflation pressures via the currency. Against this backdrop, JGBs will continue to outperform other DM bond markets during this move towards strong growth and less accommodative monetary policies outside of Japan. Stay overweight Japan against global hedged bond benchmarks. Canada: underweight duration, underweight country allocation, flatter yield curve, long inflation protection We moved our Canadian country allocation to underweight last week in advance of the BoC's expected rate hike, but we had been recommending bearish Canadian trades (curve flatteners and spread wideners versus U.S. Treasuries) in our Tactical Overlay Trade Portfolio for much of the year so far.2 The BoC's 180-degree policy shift over the past month has taken many investors by surprise, but the very strong upturn in the Canadian economy is forcing the BoC into action. With the BoC now projecting the Canadian output gap to be closed this year, expect another one, even two, rate hikes by the end of 2017. This will put additional upward pressure on Canadian bond yields and bear-flatten the Canadian government bond yield curve (Chart 10). Australia: neutral duration, neutral country allocation, neutral curve Australia has been one of the trickier markets on which to have a strong opinion, given the combination of a tight labor market, low inflation, mixed readings on domestic demand and heavy exposure to China's economy. This has led us to be neutral across the board on Australian bonds (Chart 11). We will be covering the outlook for Australia in a Special Report to be published next week, in which we will re-examine our current Australia recommendations. Chart 9Japan Rates Strategy Summary Japan Rates Strategy Summary Japan Rates Strategy Summary Chart 10Canada Rates Strategy Summary Canada Rates Strategy Summary Canada Rates Strategy Summary Chart 11Australia Rates Strategy Summary Australia Rates Strategy Summary Australia Rates Strategy Summary Bottom Line: Many central banks are responding to the strong global economic backdrop by signaling not only a shift in the bias of monetary policy, but actual changes in interest rates or asset purchases. We continue to recommend a below-benchmark overall portfolio stance, but with more diverse views on country allocation: underweight the U.S., Euro Area, & Canada; maximum overweight on Japan; and neutral on the U.K. and Australia. Expect steeper yield curves in the U.S., Euro Area and U.K., and continued flattening in Canada. An Update On The State Of U.S. Corporate Bond Market Liquidity In the Fed's latest Monetary Policy Report, presented by Janet Yellen to the U.S. Congress last week, an entire section was devoted to the state of U.S. corporate bond market liquidity.3 The Fed's conclusion was that, according to many commonly used metrics like average bid/ask spreads, corporate debt has not become more difficult to trade in recent years. This goes against the intuition of many bond investors who have perceived a deterioration of liquidity in corporate credit markets since the 2008 Financial Crisis. The Fed likely felt compelled to dedicate three pages of its Monetary Policy Report to a topic as mundane as bond market functionality as a defense of its current regulatory framework for U.S. banks. The Fed has taken a lot of flak from major U.S. financial institutions, conservative free-market politicians and, since last November, the Trump White House over the "heavy-handed" rules shackling the banks. Chart 12U.S. Dealers Don't Matter U.S. Dealers Don't Matter U.S. Dealers Don't Matter Regulations such as the Volcker Rule and the Supplementary Leverage Ratio have almost certainly reduced the odds of another financial crisis caused by undercapitalized banks speculating in risky assets. Yet the critics continue to point out that banks which are more worried about meeting regulatory targets are less able to make loans or, in the case of investment banks, make markets in risky assets like corporate debt. This is important for bond investors given the sharply reduced footprint of investment banks in corporate debt markets. The Fed's data on primary dealer positioning in corporates shows a massive decline from the pre-crisis peak in 2007 of $280bn to only $20bn this year (Chart 12). Over the same period, the size of the U.S. corporate bond market has more than tripled to $6.5 trillion (using the market capitalization of the Barclays Investment Grade and High-Yield indices as a proxy). On the surface, that indicates that dealers held 10% of "the market" at the peak. Now, dealer inventories barely represent only 0.3% of corporate debt outstanding. While that is low, it is not much lower than the share of corporates held by dealers in the early 2000s. When looking at the full span of the available data, the huge dealer footprint in the U.S. corporate bond market in the years prior to the Financial Crisis was the exception and not the norm. Like most other market participants in those years, the investment banks were seduced by the extended period of low macro and market volatility and ended up taking too much risk on their balance sheets. Now, dealers are much more cautious when trading with clients, acting more as an "agent" that matches buyers and sellers for individual trades and less as a "principal" that holds the bonds themselves. The smaller presence of dealers could create a liquidity problem for corporate debt, especially if dealers in their usual role as market-makers cannot be there to absorb the selling pressure from investors during market sell-offs. Yet corporate bond markets have functioned well since the dark days of the Lehman crisis. According to data from SIFMA, average daily trading volumes in the U.S. corporate bond market rose from a low in 2008 of $14bn to $30bn in 2016 (Chart 13). Corporate bond issuance has surged as well, but corporate bond turnover - total annualized trading volumes relative to total bonds outstanding - has improved by nearly 35% since the 2008 low. In addition, the reduced dealer presence has not resulted in any unusual widening of typical relationships like the basis between Credit Default Swaps and corporate bond spreads (bottom panel). The Fed noted this in its Monetary Policy Report as a sign that market liquidity was not impaired since there were not many "unrealized arbitrage opportunities". It is evident that other market participants have picked up the slack from the dealers in U.S. corporate bond trading. Exchange Traded Funds (ETFs) are the obvious candidate, led by the popular iShares HYG and the SPDR JNK funds that have a combined $30bn in assets under management. According to the Fed's database on the Financial Accounts of the United States (formerly known as the Flow of Funds), the share of corporate bonds held by all retail funds, including ETFs, soared from 6.5% in 2008 to nearly 19% in Q1 of this year (Chart 14). This nearly offset the decline in the share of corporates held directly by households, as individual investors shifted their preferences toward the ease of trading corporate debt ETFs over individual bonds. Chart 13U.S. Corporate Bond Market Turnover Has Improved U.S. Corporate Bond Market Turnover Has Improved U.S. Corporate Bond Market Turnover Has Improved Chart 14Shifting Ownership Patterns For U.S. Corporates Shifting Ownership Patterns For U.S. Corporates Shifting Ownership Patterns For U.S. Corporates Importantly, institutional investors like insurance companies and pension funds have seen their influence in corporate bond markets increase, as they now hold a combined 35% of corporate debt, up from 26% in 2008 (bottom two panels). These groups will likely control an even greater share of the corporate bond market in the years to come with the growing usage of so-called "all-to-all" electronic trading platforms like MarketAxess or Bloomberg that allow users to trade directly with each other. All-to-all has already established a major market footprint, as activity on MarketAxess now represents 16% of all trading volume in U.S. Investment Grade corporates and 34% for High-Yield, according to The Economist.4 This is a hugely important development. If more professional bond investors can now transact directly with one another, this helps to alleviate any reduction in market liquidity caused by a smaller dealer presence in the market. Even with so much evidence pointing to no serious liquidity problems in U.S. corporate debt, some worrisome issues remain. Chart 15Market Performance Leads Fund Inflows,##BR##Not Vice Versa Market Performance Leads Fund Inflows, Not Vice Versa Market Performance Leads Fund Inflows, Not Vice Versa Average trade sizes in corporates are smaller now compared to pre-crisis levels - perhaps as much as 20% smaller according to estimates by the New York Fed.5 This is likely the result of the reduced risk-taking by the dealers and the growing share of direct electronic trading. This creates an effect where it may feel like liquidity is impaired since it now takes longer to execute a large bond trade, even though transaction costs for individual trades have not been increasing, on average. Corporate bond ETFs are easier to trade than the underlying bonds held in the ETFs themselves. This has worried many investors who fear that a corporate bond market downturn could turn into a much larger rout if rapid ETF redemptions cause "fire sales" of the bonds held in the ETFs to quickly raise cash. Admittedly, the unique ETF structure - where the shares of the ETF are traded and not the underlying bonds, similar to a closed-end mutual fund - has not yet been tested in a true credit bear market. However, there have been several episodes of "risk-off" bond sell-offs over the past few years, most notably for High-Yield ETFs during the 2014/15 oil bear market, which did not result in any disorderly disruption of corporate bond markets. If anything, the historical experience of U.S. corporate bond mutual funds shows that net flows into funds tend to follow, and not lead, the performance of markets (Chart 15). This may exaggerate bond market moves at turning points but, in general, outflows are a symptom, not a cause, of corporate bond downturns. Net-net, we agree with the assessment of the Fed that corporate bond market liquidity shows little sign of impairment and does not represent a threat to market stability. Bottom Line: There are few signs of diminished liquidity in U.S. corporate bond markets, despite the sharply reduced inventories of primary dealers. ETFs and institutional investors have picked up the slack from the dealers, as has electronic trading directly between market participants. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 https://www.wsj.com/articles/draghi-may-address-future-of-ecb-stimulus-at-jackson-hole-1499944342 2 Please see BCA Global Fixed Income Strategy Weekly Report, "Dangerous Duration", dated July 11 2017, available at gfis.bcaresearch.com. 3 https://www.federalreserve.gov/monetarypolicy/files/20170707_mprfullreport.pdf 4 https://www.economist.com/news/finance-and-economics/21721208-greater-automation-promises-more-liquidity-investors-digitisation-shakes-up 5 http://libertystreeteconomics.newyorkfed.org/2015/10/has-us-corporate-bond-market-liquidity-deteriorated.html Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Interest Rate Strategy For The Remainder Of 2017 Global Interest Rate Strategy For The Remainder Of 2017

Dear Client, I am visiting clients this week, and as such there will be no Weekly Report. Instead, we are sending you this Special Report written by my colleague Jonathan LaBerge. Jonathan argues that while the recent acceleration of the Canadian economy is genuine, the rise in Canadian household debt-to-income over the past 16 years has been so large that a credit-driven downturn in spending is now virtually unavoidable over the long run. I hope you will find this report both interesting and informative. Best regards, Peter Berezin, Chief Strategist Global Investment Strategy Highlights The recent economic improvement in Canada is genuine. In isolation, this supports the Bank of Canada's decision to gradually raise interest rates. However, over the long run, the historical experience suggests that the substantial leverage of Canadian households will ultimately cause a serious credit-driven downturn. Several myths about Canada's housing market have obscured the true extent of its credit market imbalances, heightening the risk that policymakers will ultimately overplay their hand when tightening monetary conditions. There are multiple potential triggers that could eventually spark a credit-driven downturn in Canada, but none of them seem likely to have a major impact on the economy over the coming 6-12 months. Favor a pro-cyclical stance over the coming year, but look to shift to a bearish structural view at some point beyond the immediate investment horizon. Feature Several developments over the past few months have altered the outlook for the Canadian economy. However, these events have not had a consistent impact on the narrative for Canadian assets. Whereas a sharp rebound in real GDP growth and a hawkish pivot from the Bank of Canada have been signs of a strengthening economy, the crisis surrounding Home Capital Group (a Canadian non-bank mortgage lender) was an ominous sign for many investors concerned about the deeply imbalanced Canadian housing market.1 In this report we argue that the cyclical improvement in the Canadian economy is legitimate, and that the Bank of Canada is likely to move forward with gradual policy tightening following Wednesday's move. However, the rise in Canadian household debt-to-income over the past 16 years has been so large that a credit-driven downturn in spending is now virtually unavoidable over the long run, rather than a risk. We highlight how, in many ways, the imbalances in the Canadian housing market are even worse than the market narrative would suggest. We also provide a checklist of factors to monitor in order to judge when Canada's day of reckoning will arrive. For now, it does not appear to be imminent. From an investment standpoint, our conclusions imply that investors should pursue a "two-staged" approach when allocating to Canadian assets. Over the coming 6-12 months, a cyclical improvement in the economy means that Canadian risky asset prices and government bond yields are likely to rise, and we believe that this stage is worth playing. But over the secular horizon, the reverse is likely to unfold, meaning that a rally in Canadian assets over the coming year will create excellent "selling conditions" for investors looking to position for a bearish structural view. Economic Momentum Is Spurring Tighter Monetary Policy... The Bank of Canada is now back on a path towards tighter monetary policy, and a close examination of the Canadian economy, as well as our outlook for global oil inventories, supports the BoC's view: Real consumer spending picked up significantly in Q1, rising from 2.7% to 3.1% on a year-over-year basis. Chart 1 highlights that the rise in real spending has been supported by a rebound in employment growth and consumer confidence (the latter is at a 9-year high). On the employment side, Chart 1 also shows that the acceleration in job growth is not limited to provinces that are strongly associated with oil sands production. In fact, the chart shows that employment in Canada excluding Alberta and Saskatchewan has been in an uptrend since mid-2014, when fiscal and monetary policy began to respond to the shock from a collapse in the price of oil. All Canadian employment cylinders are now firing, given the job recovery in oil sands provinces. Real Canadian gross fixed capital formation turned positive in Q1 after a significant decline into negative territory, and a simple model based on business confidence, oil prices, and the Canadian dollar (stripped of its correlation with oil) suggests that it will continue to accelerate modestly over the coming year (Chart 2). Chart 1Genuine Signs Of A Stronger Economy Genuine Signs Of A Stronger Economy Genuine Signs Of A Stronger Economy Chart 2Further Gains In Investment Likely Further Gains In Investment Likely Further Gains In Investment Likely Chart 3 shows a model for oil prices, based on global industrial production, oil production, OECD oil inventories, and oil consumption in the major countries and China. If OPEC is successful in reducing inventories to their 5-year moving average, as BCA's commodity strategists expect, the model implies that oil prices will rise materially. This is likely to provide a tailwind for the Canadian economy, at least in nominal terms. While the pace of tightening is likely to be gradual because of the weakness in Canadian core inflation, Chart 4 suggests that the decline in inflation over the past few months may simply represent the correction towards more fundamentally-justified levels. The chart shows a model of core inflation based on lagged real core consumer spending and the Canadian dollar (as a proxy for imported inflation/deflation), and highlights that actual inflation has overshot the model value over the past three years. But the chart also shows that the fundamentally-justified level of core inflation remains in an uptrend, suggesting that recent weakness is likely temporary and is thus not an impediment to higher policy rates over the coming year. Chart 3Falling Inventories Will Be Bullish For Oil Falling Inventories Will Be Bullish For Oil Falling Inventories Will Be Bullish For Oil Chart 4The Dip In Core Inflation Is Temporary The Dip In Core Inflation Is Temporary The Dip In Core Inflation Is Temporary Bottom Line: The recent economic improvement in Canada is genuine and, in isolation, supports the Bank of Canada's decision to gradually raise interest rates. ...But It Will All Likely End In Tears Chart 5Higher Household Leverage Than In The U.S. Pre-Crisis Higher Household Leverage Than In The U.S. Pre-Crisis Higher Household Leverage Than In The U.S. Pre-Crisis While we agree that the Bank of Canada is on a path to gradually raise interest rates over the coming year and that the economy is currently in good shape, the odds are good that tighter policy (and/or other factors) will eventually inflict considerable damage to the Canadian economy via the housing market and its impact on highly leveraged consumers. In this regard, the pickup in Canadian economic growth likely represents a happy moment in an otherwise sad story. Chart 5 compares Canada's mortgage debt-to-disposable income, total household debt-to-GDP, and the total household debt service ratio to that of the U.S. The chart neatly illustrates the fundamental basis for a bearish secular outlook for the Canadian economy, which is that household debt levels have risen enormously since 2000, to a level that is worse today than in the U.S. in 2007. "So what?" ask some investors. Household debt levels vary significantly across countries, meaning that an elevated level of household debt-to-income does not necessarily spell economic doom. Chart 6 counters this point by showing the relationship between the historical change in household debt-to-GDP (y-axis) versus the starting point for the ratio (x-axis) during episodes of significant household leveraging. The change in debt-to-GDP is shown as a 10-year average of the year-over-year change in the ratio, in order to compare Canada's recent debt binge with other long-term booms in credit. In terms of very significant increases in household credit-to-GDP from an already above-average level, Chart 6 shows that Canada's experience (an average yearly increase of 3.3%) has been among the most severe cases. The chart also shows that while there are a few exceptions, other observations in the neighborhood of Canada's have had a strong tendency to be associated with harsh economic consequences once the credit binge has come to an end. In particular, while the chart shows that the countries at the center of the euro area sovereign debt crisis saw a more rapid rise in household debt-to-GDP than observed in Canada, this occurred from a lower base. When measuring the total change in household debt-to-GDP, Canada has experienced almost the same magnitude rise from 2000 to today as what occurred in Spain and Portugal during the last economic cycle. In terms of a comparison with the U.S., Chart 7 presents a long-term perspective on the inverse relationship between household credit growth and real per capita consumption in the U.S. The chart highlights that 10-year upcycles in household debt-to-GDP correlate well, with a lag, to 10-year downcycles in real per capita spending. Periods where the relationship is less tight have tended to be associated with less severe increases in household debt-to-GDP, suggesting that investors can be more confident that debt growth will eventually negatively impact consumer spending the stronger the credit binge has been. Chart 6The Historical Experience Of Household Leveraging Does Not Paint A Pretty Picture For Canada Canada: A (Probably) Happy Moment In An Otherwise Sad Story Canada: A (Probably) Happy Moment In An Otherwise Sad Story Chart 7Upcycles In Household Leveraging Correspond To Downcycles In Real Spending Upcycles In Household Leveraging Correspond To Downcycles In Real Spending Upcycles In Household Leveraging Correspond To Downcycles In Real Spending As a final point, Chart 7 underscores a sobering fact: The U.S. has only seen two instances of a 3% or greater average annual rise in household debt-to-GDP over the course of a decade: the first was in the 1920s, and the second was from 1998 to 2007. Clearly, in both cases the rise in debt ended very poorly for the U.S. economy. This, along with the prevalence of serious debt crises following credit binges similar in magnitude to Canada's experience, makes it clear that a credit-driven downturn in spending is a highly probable event for the Canadian economy over the long run, rather than a risk. Bottom Line: The available historical evidence suggests that the substantial leveraging of Canadian households that has already occurred will ultimately cause a serious credit-driven downturn. Debunking Some Housing Market Myths: It's Worse Than You Think Chart 816 Years Of Too-Easy Money 16 Years Of Too-Easy Money 16 Years Of Too-Easy Money The risk that the Bank of Canada will eventually "over-tighten" is magnified by the fact that there is still an ongoing debate within Canada about whether any housing market imbalances even exist. Many market participants still employ several arguments about the Canadian housing market that, at first blush, appear to mitigate the risk of serious long-term consequences of Canada's debt boom. But these arguments are flawed, and an in-depth review of these fallacies highlights the economic risk of higher interest rates. Myth #1 - Sustainable Demand And Affordability The first myth about Canada's housing market is that the rise in house prices and household debt is sustainable because of how long the boom has lasted without consequence. However, besides the ominous historical experience highlighted in Charts 6 and 7 above, Chart 8 makes it clear that the substantial build-up in Canadian household debt since 2000 has occurred primarily due to too-easy monetary policy, rather than legitimate housing market fundamentals. The chart presents Canadian household debt-to-GDP versus the Bank of Canada's target for the overnight rate. The dotted line in panel 2 is a Canadian version of the well-known Taylor rule of monetary policy, with panel 3 showing the difference between the actual policy rate and that prescribed by the rule. The chart shows that the rise in household debt-to-GDP began precisely when the policy rate fell below the Taylor rule, and that this gap has persisted for the past 16 years. We acknowledge that the Bank of Canada felt it was necessary to keep interest rates relatively low during the last economic cycle because of the persistent strength in the Canadian dollar (which acts to restrain exports). But whatever drag on growth that occurred from a strong currency was not large enough to prevent low interest rates from sparking an enormous rise in household leverage. Myth #2 - No Foreign Money Effect The second myth about the Canadian housing market is that there is no substantial effect on house prices from foreign money and that, by extension, foreign transaction taxes should be discouraged. To us, the issue is not the specific residency status of a particular buyer, but rather whether the housing market is being supported by an inflow of foreign capital. While data limitations make it difficult to prove with certainty that Canada has been struck with a tidal wave of capital from China (with Hong Kong acting as the conduit), Charts 9 and 10 show that the circumstantial evidence is overwhelming. The story that emerges from the charts is that the peak in Chinese real GDP growth in 2010 marked the beginning of significant capital outflow from the country, which appears to have moved through Hong Kong, and was perhaps accelerated by Xi Jinping's crackdown on cronyism that began in 2013. Panel 2 of Chart 9 shows that the average absolute value of Hong Kong's "net errors and omissions" line from the balance of payments spiked after mid-2010,2 as did Canada's "other investment liabilities" with a lag. Chart 10 shows that this period also saw a sharp rise in visitor arrivals to Canada from China and Hong Kong, a rise in the share of Canadian bank loans to nonresidents, and a meteoric rise in house prices in Vancouver and Toronto. Chart 11 presents data from Global Financial Integrity, a Washington-based think tank that tracks illicit financial flows globally. While the data is only available with a lag, the chart shows that GFI's estimate of illicit financial outflows from China has risen significantly following the global financial crisis, which is consistent with the narrative presented in Charts 9 and 10. Chart 9Very Strong Circumstantial Evidence... Very Strong Circumstantial Evidence... Very Strong Circumstantial Evidence... Chart 10...Of Foreign Capital Inflows ...Of Foreign Capital Inflows ...Of Foreign Capital Inflows Chart 11Clear Evidence Of Chinese Capital Flight Clear Evidence Of Chinese Capital Flight Clear Evidence Of Chinese Capital Flight Myth #3 - Tight Supply The third myth concerning Canadian housing is the argument that housing supply is tight, which justifies the exponential move in house prices. First, it should be noted that while residential investment as a share of GDP was indeed low in the late-1990s, it rose back to its long-term average within the first three years of the housing boom, and has recently risen to a 27-year high (Chart 12). A similar trend can be observed in housing starts and the number of unsold housing inventories. As such, it seems difficult to make the case that the extraordinary rise in house prices and household debt that we have observed over the past 16 years is ultimately due to scarce housing supply. Chart 13 makes this point more saliently, by presenting a scatterplot of the median house price-to-income ratio versus the population density of several major global markets. Ultimately, in any true market economy, genuine housing supply constraints must be related to high density or else there would be ample room to build additional housing units. Two points are noteworthy: Chart 12There Is No Supply Problem There Is No Supply Problem There Is No Supply Problem Chart 13'There's Nowhere To Build!': Yeah, Right! Canada: A (Probably) Happy Moment In An Otherwise Sad Story Canada: A (Probably) Happy Moment In An Otherwise Sad Story The median house price-to-income ratio for Toronto and Vancouver deviate enormously from the level that would be implied by their density given the relationship across global housing markets. Based purely on this analysis of relative density, Toronto and Vancouver house prices are 80% and 140% overvalued, respectively. Around the globe, the housing markets that appear to be the most overvalued relative to population density appear to be the geographically closest to China (Vancouver, Australia, Hong Kong, and the West Coast of the U.S.), which echoes our conclusions about foreign capital inflow above. Myth #4 - A Healthier Canadian Household Debt Distribution The fourth myth concerning Canadian housing is the idea that the household debt binge that we have observed has been a "healthier" rise than what occurred in the U.S. during the last economic cycle. The argument is that the rise in debt in the U.S. from 2001 - 2007 predominantly occurred among "subprime" borrowers, and that this is not occurring in Canada. Comparing Canada to the U.S. last cycle is difficult due to the lack of data on the distribution of Canadian household debt-to-income ratios by income percentile. However, some inferences can be drawn from the OECD's wealth distribution database, and they suggest that Canadian household debt is, in fact, quite concentrated. Chart 14 presents the relationship between the number of households with debt and the median debt-to-income ratio of indebted households, from 2010 to 2012 (depending on the observation). The chart shows that while only about half of Canadian households are indebted (in line with the average of the countries shown and below that of the U.S.), among those with debt the median debt-to-income ratio is substantially higher than most other countries. This is also reflected in Chart 15, which shows that Canada has a high rank of significantly indebted households as a share of all indebted households,3 more so that the U.S. Investors should note that Canada's rank today is likely to be higher than that shown in Chart 15, given that several other highly indebted countries (such as the Netherlands and Portugal) have actually experienced household deleveraging since 2010. Chart 14High Concentration... Canada: A (Probably) Happy Moment In An Otherwise Sad Story Canada: A (Probably) Happy Moment In An Otherwise Sad Story Chart 15...Of Household Indebtedness Canada: A (Probably) Happy Moment In An Otherwise Sad Story Canada: A (Probably) Happy Moment In An Otherwise Sad Story Myth #5 - The "CMHC Backstop" The fifth and final myth concerning Canadian housing is the fact that the economy is not significantly exposed to a housing market downturn because of the Canada Mortgage and Housing Corporation's mortgage insurance coverage protects Canadian banks. It is true that the CMHC can act as a backstop for the economy by helping to mitigate mortgage default losses. But Chart 16 highlights that there have been some substantial changes over the past few years in the CMHC's footprint in the mortgage market that casts significant doubt on whether it would be able to materially blunt the losses that are likely to occur from systemic mortgage defaults. First, the chart shows that while half of mortgages in Canada had CMHC insurance coverage in 2010, this has fallen by 14 percentage points in just six years (to 36%). This means that almost 2/3rds of Canadian mortgages are not CMHC-insured. Second, while the CMHC has been aggressive in building equity over the past several years (perhaps in anticipation of a significant housing bust!), this equity buffer is still small relative to its total loans (9%) and is fractional as a share of total Canadian residential mortgage credit (1.5%). As such, while we agree that the CMHC is an effective backstop against idiosyncratic risk in the mortgage market, it is simply too small to act as a credible buffer against large-scale losses. Bottom Line: Several myths about Canada's housing market have obscured the true extent of its credit market imbalances, heightening the risk that policymakers will ultimately overplay their hand when tightening monetary conditions. When Will The Party Come To An End? From our perspective, the most likely catalysts for a credit-driven downturn in spending are a reversal of the factors that drove the rise in household debt in the first place. Chart 17 presents a three-phase view of the rise in household debt-to-income since 2000, and summarizes the major drivers of rising leverage in each phase given our analysis above: persistently easy monetary policy (phase I), fiscal and monetary easing (phase II), and foreign capital inflow (phase III). Given this, higher interest rates, fiscal drag, and/or a shock to foreign capital would appear to be the most likely triggers for a credit-driven downturn: Chart 16A Substantially Lower CMHC Footprint A Substantially Lower CMHC Footprint A Substantially Lower CMHC Footprint Chart 17The Major Drivers Of Rising Household Leverage The Major Drivers Of Rising Household Leverage The Major Drivers Of Rising Household Leverage Higher Interest Rates: Tighter monetary policy is an obvious (and most likely) trigger for a major reversal in the Canadian housing market. It is not yet clear how aggressively the Bank of Canada will raise interest rates over the coming 6-12 months, but Chart 18 highlights that the household debt service ratio will quickly rise to a new high even if the Bank of Canada hikes rates by 150 bps over a two-year period, owing to the relatively short maturity of Canadian mortgage contract terms. Still, the chart shows that this does not occur until mid-2019 at the earliest. Fiscal Drag: IMF forecasts for Canada's cyclically-adjusted primary balance suggest that government spending and investment will remain a positive contributor to growth into next year (Chart 19). But beginning in 2019, fiscal policy is forecast to become a persistent drag on growth, and it is even possible that the sharp deceleration in fiscal thrust set to occur next year could act as the proximate cause of serious problems in the Canadian housing market. Chart 18Not An Imminent Threat, But Watch Out Not An Imminent Threat, But Watch Out Not An Imminent Threat, But Watch Out Chart 19Fiscal Drag Set To Begin In 2019 Fiscal Drag Set To Begin In 2019 Fiscal Drag Set To Begin In 2019 Chart 20Macroprudential Measures Didn't Kill The Vancouver Housing Market Macroprudential Measures Didn't Kill The Vancouver Housing Market Macroprudential Measures Didn't Kill The Vancouver Housing Market A Domestically-Driven Shock To Foreign Capital Inflow: Some investors have pointed with concern to dramatic declines in the sales-to-listings ratios in Vancouver and Toronto following foreign taxation announcements in these markets. We agree that the impact of new or existing macroprudential measures may eventually cause a severe fallout in the housing market, but for now the experience of Vancouver suggests that such an event is not imminent. Chart 20 presents the 3- and 12-month rate of change in Vancouver house prices, with the vertical line denoting the announcement of the foreign transaction tax. While it is clear that the tax sharply slowed the rate of appreciation in Vancouver house prices, it did not cause an outright decline (the 3-month rate of change only briefly turned negative before returning to positive territory). Cyclically, we would become more concerned were we to observe a combination of additional restrictions on foreign capital inflow, higher minimum down payment thresholds for houses priced at or below median levels, and a significantly lower allowable gross/total debt service ratio. An Externally-Driven Shock To Foreign Capital Inflow: We noted earlier in the report that there is strong circumstantial evidence showing that Canada's property market is benefiting from large capital inflows from China, with Hong Kong acting as the conduit. Given this, the Canadian housing market could be subject to a shock from exogenous changes in the flow of this capital, perhaps triggered by cyclical changes in China's economy or, more likely, actions by Chinese policymakers to materially slow the pace of capital flight. While it is very difficult on a high frequency basis to track whether the impact of foreign capital on Canada's housing market is growing or weakening, the indicators shown in Charts 9 and 10 on page 9 form the basis of our monitoring effort. The list above has focused on potential triggers that are specific to the factors that led to the build-up in Canadian household debt. Clearly there are additional macro factors that could trigger the onset of a major debt payback period in Canada, and chief among these would be the next U.S. or global recession. For example, we recently noted how continued tightening from the Fed could set the stage for a U.S. recession in 2019, which could easily trigger either a prolonged period of stagnant Canadian growth or an active deleveraging event.4 Bottom Line: There are multiple potential triggers that could eventually spark a credit-driven downturn in Canada, but none of them seem likely to have a major impact on the economy over the coming 6-12 months. Investment Implications Canadian household leverage has risen enormously over the past 16 years, and a detailed analysis of Canada's housing market shows that an eventual credit-driven downturn in spending is a highly probable event for the Canadian economy over the long run (rather than a risk). However, among the most probable triggers for a serious housing market shock, only higher interest rates are set to occur over the coming year. Given that monetary tightening will be gradual in its pace, it does not seem probable that a major downturn in spending is imminent. From an investment standpoint, these conclusions imply the following stance towards Canadian dollar assets over the coming 6-12 months: Overweight the Canadian dollar: The cyclical improvement in the Canadian economy, along with our bullish view on oil prices, suggests that the Canadian dollar is set to appreciate over the coming year. We acknowledge that our constructive view on oil prices is contrarian and that, for now, we are ahead of the market. Continued weakness in oil prices remains the chief risk to a bullish stance on the CAD. But our detailed analysis of the global oil market strongly implies that the current level of oil inventories is too high and is set to draw materially over the coming months, which will be undoubtedly positive for oil prices barring the development of a major global demand shock. Maintain Canadian equities on upgrade watch: Canadian equities have materially underperformed their global peers over the past six years, due to fairly significant de-rating from overvalued levels as well as a downtrend in relative 12-month forward earnings (mostly vs the U.S.; Chart 21). Relative performance in common-currency terms has also been hurt by a declining Canadian dollar. Looking out over the next year, there are at least some tentative signs to be optimistic about Canadian stocks. First, Chart 22 highlights that Canadian stocks are now moderately cheap relative to their global peers based on a composite valuation indicator. Second, our expectation of an uptrend in oil prices would likely bolster relative forward earnings, and could act as a re-rating catalyst for the broad market. Chart 21Multiples And Earnings Have Worked Against Canadian Stocks Multiples And Earnings Have Worked Against Canadian Stocks Multiples And Earnings Have Worked Against Canadian Stocks Chart 22No Longer Expensive No Longer Expensive No Longer Expensive Underweight Canadian bonds within a hedged global fixed-income portfolio: Canadian government bonds have recently underperformed their global peers, and this trend is likely to continue in response to tighter monetary policy. Over the longer term, the likelihood of a major credit-driven downturn in spending means that the secular investment implications for Canada are precisely the opposite of that described above. This means that investors should pursue a "two-staged" approach to investing in Canadian assets. The fact that the Canadian economy is currently accelerating and a significant reversal in the Canadian housing market does not seem to be imminent means that there is an opportunity for Canadian assets to potentially outperform (or underperform in the case of government bonds) over the coming 6-12 months. Such a period of cyclical improvement would likely (temporarily) dampen investor concerns about a major housing market correction, creating much better "selling conditions" for Canadian risky assets than from current levels. We acknowledge that the "two-stage" nature of this strategy is nuanced, and we have provided a checklist of potential triggers for the housing market in this report so that investors can gauge the likelihood that a material payback period is about to begin. We will continue to monitor both the cyclical improvement in the Canadian economy and the magnitude of imbalances in the household sector, and will provide investors with regular updates as they develop. Stay tuned! Bottom Line: Investors should pursue a "two-staged" approach when allocating to Canadian assets. Favor a pro-cyclical stance over the coming 6-12 months, but look to shift to a bearish structural view at some point beyond the immediate investment horizon. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Appendix A A Quick Recap Of Home Capital: Not A Systemic Issue In April, the share price of Home Capital Group (a Canadian non-bank mortgage lender) collapsed by 75% in response to a major liquidity crisis for the firm. The crisis ultimately stemmed from a set of mortgage loans with falsified income documentation, which to many outside observers was strongly reminiscent of the aberrant practices of U.S. subprime lending institutions during the last cycle that eventually spawned the global financial crisis. However, as highlighted below, Home Capital Group's problems were largely idiosyncratic (i.e., not systemic) in nature: Home Capital's business model involves lending to Canadians who lack a stable credit history, but who are generally otherwise creditworthy (commonly referred to as "near-prime" borrowers). Since these borrowers subsequently build a credit history by staying current on their mortgage loans with Home Capital, they often switch to a big-five bank after the term of the loan is complete. As such, Home Capital faces substantial client retention challenges, which is an idiosyncratic income statement problem rather than a balance sheet problem with systemic implications. To combat the tendency of its loan book to shrink, in 2014 Home Capital increased the size of its sales force by partnering with a set of established mortgage brokers. Some of the loans that had been originated by these brokers had falsified income documentation, which led to an internal investigation. Following the investigation, the company failed to disclose the results to investors during a period where the company's operating performance was impacted by the fraud. This eventually led to enforcement action from the Ontario Securities Commission. The disclosure of enforcement, along with several other events (such as the termination of its CEO in late-March) severely eroded investor confidence in the firm and essentially caused a bank run. From a macro perspective, there are two important takeaways from this series of events. First, it is important to note that Home Capital experienced a liquidity rather than a solvency crisis. While the former can, of course, lead to the latter, the run on Home Capital did not occur because of deteriorating loan performance, unlike what occurred in the U.S. with the subprime market. Indeed, Home Capital's first quarter results show that net impaired loans as a percent of gross loans have continued to trend lower over the past several quarters (Chart A1). Second, the fact that Home Capital's mortgage book tends to shrink underscores the underlying creditworthiness of at least some of its borrowers, because these households would probably not be able to shift their mortgages to the big-five banks if loan qualification was an issue. As a final point, Chart A2 presents some perspective about the apparent prevalence of mortgage fraud in Canada by showing the number of U.S. mortgage loan fraud suspicious activity reports (SARs) in the lead-up to the subprime financial crisis. The chart not only shows the sharp rise in the number of SARs from 2002-2003 to 2007-2008, but it also shows that the volume of reports numbered in the tens of thousands. By contrast, Canadian news stories reporting on a rise in the number of mortgage fraud complaints in Canada quote a trivially small number of cases. For example, a recent article from the Vancouver Sun stated that British Colombia's Financial Institutions Commission statistics "show complaints roughly doubled from 109 in 2013 to about 200 in 2016, and about a third of complaints allege loan application fraud."5 Chart A1No Deterioration In Loan Performance Canada: A (Probably) Happy Moment In An Otherwise Sad Story Canada: A (Probably) Happy Moment In An Otherwise Sad Story Chart A2No Evidence That This Is Happening In Canada Canada: A (Probably) Happy Moment In An Otherwise Sad Story Canada: A (Probably) Happy Moment In An Otherwise Sad Story While it is technically correct to state that this is a doubling in the rate of fraud cases, it is from what appears to be an extremely small base. Adjusting by a factor of 10 to account for the difference in population, Canada would need to see 3,000-to-6,000 cases of mortgage fraud per year in order to be comparable to what occurred in the U.S. in the latter half of the housing market bubble. There is simply no evidence that mortgage fraud on this scale of magnitude is occurring. 1 See Appendix A on page 19 for a review of the Home Capital debacle and why concerns of systemic mortgage fraud are quite likely overblown. 2 If Hong Kong has been a conduit for capital flight from China, the flow of capital would only temporarily show up in Hong Kong's balance of payments. For example, one quarter of significant capital inflow might be followed by a quarter of significant capital outflow as the money enters from China and exits towards the rest of the world. As such, we use the absolute value of Hong Kong's net errors and omissions line to see whether the magnitude of the flow has increased. 3 Defined as having a debt-to-income ratio in excess of 3. 4 Please see Global Investment Strategy Weekly Report, "The Timing Of The Next Recession," dated June 16, 2017, available at gis.bcaresearch.com. 5 Sam Cooper, "Regulator Tracks The Rise In Mortgage Fraud Complaints In B.C. As House Prices Jump," Vancouver Sun, June 19, 2017. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Yellen pointed out that the U.S. R-star is low but that it will rise as temporary depressing factors pass. The Fed is determined to push rates toward 3% over time. The euro area R-star is substantially lower than that of the U.S., limiting the capacity of the ECB to follow the Fed's path and pace. Traders are massively long the euro. Abe's woes do not signal the end of Abenomics, in fact they point toward more stimulus. The BoC has hiked and will keep doing so, continue to favor the CAD. Feature Janet Yellen offered both a fascinating and telling glimpse on the Federal Reserve's thinking this week. She argued that the equilibrium fed funds rate is currently very depressed, which is limiting the pace at which the FOMC can increase interest rates before plunging the economy into recession. However, she also noted that the Fed anticipates equilibrium interest rates will continue to rise over time, which means the actual fed funds rate has more upside on a multi-year horizon, despite what will be a slow pace of increases. With this additional information on the Fed's mindset, investors should be even more comfortable in their assessment that the period of maximum policy divergence between the euro area and the U.S. is behind us, which justified bullish bets on the euro. However, the broader picture is a bit more complex. Different Equilibria The idea that the neutral fed funds rate is still low but rising explains why the Fed is still pegging its terminal rate at 3%. Currently, the Laubach and Williams formulation of the neutral real fed funds rate (also known as R-star) is at 0.4%, while the current real fed funds rate stands at -0.5%, which implies 0.9% upside in real rates over the next two years or so (Chart I-1). Moreover, if as we expect core inflation moves back toward 2% over the Fed's forecast horizon, the upside to rates would be closer to 150 basis points. In the euro area, however, the same long-term R-star stands at -0.1%, depressed by lower population growth, a higher savings rate and lower structural productivity gains. Since the real policy rate is at -0.7%, this signifies that the gap between the actual real policy rate and its equilibrium is a smaller 0.6% (Chart I-2). This means that euro area rates have much less upside than U.S. ones before generating a deleterious impact on growth. Chart I-1U.S. R-Star Vs. Policy Rates U.S. R-Star Vs. Policy Rates U.S. R-Star Vs. Policy Rates Chart I-2Euro Area R-Star Vs. Policy Rates Euro Area R-Star Vs. Policy Rates Euro Area R-Star Vs. Policy Rates It is easy to argue that R-star differences are nice theoretical concepts, with little practical implications for currency investors. After all, interest rate differentials at the long end of the curve are clearly a function of the relative GDP per capita between the euro area and the U.S. (Chart I-3). These same GDP-dynamics also have an impact - albeit a less tight one - on EUR/USD. Chart I-3Yield Differentials And Relative GDP Yield Differentials And Relative GDP Yield Differentials And Relative GDP Chart I-4How R-Star And GDP Tango How R-Star And GDP Tango How R-Star And GDP Tango Yet, R-star spreads do affect growth differentials between the euro area and the U.S. As Chart I-4 illustrates, when the euro area real policy rate crosses above its equilibrium, euro area real GDP per capita growth sags soon after. The same holds true for the U.S. This suggests the capacity of European GDP per capita to outperform that of the U.S. is currently limited, or at the very least needs rates in Europe to remain quite low relative to the U.S., anchored lower by the depressed level of the R-star in Europe vis-a-vis the U.S. Moreover, the recent outperformance of European GDP per capita relative to the U.S. has a lot to do with the poor performance of U.S. GDP in 2016. However, U.S. GDP should firm in the coming quarters, particularly since household income levels are well supported. As Chart I-5 shows, based on an average of the pay-related and hiring-related components of the NFIB small businesses survey, the aggregate wages and salaries received by U.S. households are set to accelerate, both in nominal and real terms. This represents a boost to aggregate income and should support consumption, or almost 70% of the U.S. economy. Additionally, the rebound in U.S. capex should continue. Both the NFIB and the various regional Fed capex intention surveys remain healthy. This, along with labor market tightness, should be accretive to per capita GDP. As Chart I-6 shows, a composite indicator based on the NFIB survey capex and "jobs hard to fill" components is very strong, which historically has led to an acceleration of real-GDP-per capita growth. Chart I-5U.S. Household Income Will Accelerate U.S. Household Income Will Accelerate U.S. Household Income Will Accelerate Chart I-6U.S. Real GDP Per Capita Will Strengthen U.S. Real GDP Per Capita Will Strengthen U.S. Real GDP Per Capita Will Strengthen As a result, we are inclined to bet on a renewal of strength in the U.S. economy, which will support R-star there and help the Fed hike rates by more than the 43 basis points currently anticipated over the next 24 months. Bottom Line: The U.S. long-term equilibrium real fed funds rate is low, but remains substantially higher than the R-star in the euro area. This suggests that U.S. rates have more upside than European ones. Moreover, the outlook for U.S. per capita GDP is healthy, while that of Europe will continue to require low rates to remain on an upward path. Tactical Considerations Around EUR/USD EUR/USD is well bid, and our base case scenario remains that the 1.15 to 1.16 zone will be retested. However, some technical indicators have made us leery to chase this move, and might even prevent this target zone from ever being breached. To begin with, the number of long speculative bets on the euro has hit a record high, while the number of short bets has collapsed (Chart I-7). Net long speculative positions are not at a record high yet, but are in the upper echelons of the distribution of the past 17 years. Interestingly - and some would argue almost mechanically - while speculators' optimist or pessimist extremes can be used as contrarian indicators, commercial traders tend to be disproportionally short or long the euro at the appropriate time - i.e., when the euro is set to plummet or rally, respectively. Theoretically, commercial and non-commercial traders' positions should be in perfect balance as they are counterparties to one another, but in practice this is rarely the case. Because of this observation, we decided to amplify the message of both series by subtracting the net long commercial positions from net long non-commercial ones. This indicator tends to work best at highlighting tops in EUR/USD. The current reading has been indicative of an upcoming period of weakness in this pair (Chart I-8). The only exception was in 2007, a period when unlike today, the Fed was cutting rates while the ECB policy rate was being lifted all the way to July 2008. Chart I-7Record Longs In The Euro Record Longs In The Euro Record Longs In The Euro Chart I-8Aggregate Positioning Points To A Lower Euro Aggregate Positioning Points To A Lower Euro Aggregate Positioning Points To A Lower Euro Moreover, the buying pressure on EUR/USD may be exhausting itself. Wednesday, despite a seemingly dovish message from Fed Chair Yellen and despite stronger-than-anticipated industrial production numbers out of the euro area, EUR/USD weakened 0.6% instead of appreciating. In fact, our European Investment Strategy Senior Vice President Dhaval Joshi's Fractal Dimension indicator - a measure of group-think in the market - is now at 1.25, a level that also warns of an imminent trend change (Chart I-9).1 Chart I-9A Risk Of Reversal A Risk Of Reversal A Risk Of Reversal As a result, we do not yet think it is time to be betting aggressively on a fall in EUR/USD, especially as next week's ECB meeting might give an occasion for President Mario Draghi to re-affirm his optimism, giving the euro its final push toward 1.15-1.16. However, nimble traders should begin building small short positions in the euro on the optic of expanding their bets if the EUR/USD gathers downward momentum. Bottom Line: The euro may well hit the 1.15-1.16 range, but positioning in EUR/USD is currently extremely overstretched, and the euro's trading action suggests that groupthink has become prevalent, confirming the message of positioning. This means the euro is at risk. Nimble traders should begin building small short positions in EUR/USD, but it is not yet time to bet aggressively on this pair. Shinzo's Troubles Are Not The Demise Of Abenomics Japanese Prime Minister Shinzo Abe's popularity has been in freefall in recent weeks, hitting the most dismal levels of his current premiership (Chart I-10). The flogging received by the LDP in the recent Tokyo Metropolitan Assembly election is indeed being perceived as a rejection of the party's policy stance since 2012. Does this represent the coup de grace that will end Abenomics? We doubt it. The key behind the recent dip in Abe's popularity is not his economic policy but his move away from it. Instead, his focus on changing the pacifist constitution of post-war Japan is the source of the LDP's and Abe's woes, as this topic remains anathema with the Japanese public. Moreover, we are not willing to bet on the demise of the LDP. The Tokyo election was a one-off event. The new Tomin First no Kai (Tokyoites First) party that is now the largest force in the regional assembly is led by the very popular Tokyo governor Yuriko Koike, and will rely on the pacifist Komeito to control the Tokyo Metropolitan Assembly. At the national level, the DPJ remains in tatters, and no potential new party is in place to carry the torch of the opposition. Japan is still effectively a one-party democracy. So what are the market implications of these political developments? We expect a doubling down by Abe on economic stimulus. If Abe ever wants a passing chance to have, let alone win, a referendum to increase Japan's militarism, the economy needs to be stronger than it is. Thus, we think this boot of unpopularity will be key to unlocking more fiscal stimulus out of Tokyo. When more fiscal stimulus finally does materialize, if it boosts growth, it will also lift long-term inflation expectations (Chart I-11). Chart I-10Abe's Plummeting##br## Popularity A Soft-Spoken Yellen A Soft-Spoken Yellen Chart I-11If Fiscal Stimulus Is Implemented ##br##CPI Expectations Will Rise... If Fiscal Stimulus Is Implemented CPI Expectations Will Rise... If Fiscal Stimulus Is Implemented CPI Expectations Will Rise... In this context, we would expect continued pressure on the Bank of Japan to remain one of the two most dovish central banks in the G10, as to not undo the benefits of fiscal stimulus. Moreover, the BoJ cannot remove stimulus, as realized CPI excluding food and energy remains in negative territory. Tokyo's CPI report, which offers a one-month lead on the national release, shows that core inflation is still in negative territory. National summer wage negotiations point to negative wage growth next year, making a revival of domestically generated inflation a remote event without an easing of financial conditions (Chart I-12). Additionally, the recent rollover in the leading diffusion index suggests the economic upswing may already be fading (Chart I-13). Continued BoJ support and higher inflation expectations would hurt Japanese real yields and handicap the yen. Chart I-12...But That Will Also Require Easy Monetary##br## And Financial Conditions ...But That Will Also Require Easy Monetary And Financial Conditions ...But That Will Also Require Easy Monetary And Financial Conditions Chart I-13A Slowdown ##br##In Japan A Slowdown In Japan A Slowdown In Japan The recent upswing in global bond yields is thus likely to continue to weigh on the yen, leading to a higher USD/JPY. As this week illustrated, rising global yields are forcing the BoJ to increase its amount of JGB purchases to cap the upside in Japanese 10-year yields. Tactically, USD/JPY has been in an upswing, but has hit an important resistance close to 114.5. A few more days of weakness could ensue, but such weakness should be used by investors to sell the yen. Bottom Line: Abe's political problems do not represent the end of Abenomics. Instead, they illustrate the Japanese public's lack of appetite toward abandoning Japan's post-war pacifism. If Abe is serious about holding a referendum on this topic, he will have to support growth going forward - which implies higher fiscal stimulus and inflation expectations. Meanwhile, the absence of inflation in Japan continues to hamstring the BoJ in keeping policy extremely supportive, limiting the upside to nominal interest rates across the Japanese yield curve. Real rate differentials will continue to support USD/JPY. Use any weakness in this pair to buy the dollar versus the yen. Canada: Poloz Delivers The Bank of Canada on Wednesday increased interest rates by 25 basis points to 0.75%, the first central bank to follow the Fed's lead. Our analysis two weeks ago suggested that the BoC was faced with some of the most supportive conditions in the world to follow the Fed's path.2 More interesting than the decision itself was the accompanying quarterly Monetary Policy Report. In the report, the BoC moved forward its estimation of the closure of the output gap from 2018 to 2017. Additionally, despite expecting a slowdown in household consumption in 2018, the BoC upgraded its GDP forecast by 0.2% in 2017 and 0.1% in 2018, to 2.8% and 2%, respectively. Obviously, the market took note of these views, with USD/CAD falling three big figures on the news. The tone of the report was quite bullish on the Canadian economy, highlighting robust as well as broad-based growth and increasing signs of vanishing slack. In fact, the message reiterated that of the summer Business Outlook Survey, which showed strong growth, growing difficulty meeting demand, and growing and intensifying labor shortages (Chart I-14). As a result, the BoC expects the weak Canadian CPI to rebound, after the transitory effects of low food inflation, automobile rebates, and Ontario's electricity subsidies dissipate. We are inclined to agree with this assessment. At 2% per annum, Canadian employment growth is robust and the unemployment rate has fallen significantly. Now that oil prices have stabilized, employment is improving, suggesting that even the weakest regions of the economy are participating in the party. Additionally, our Canadian economic diffusion index - based on retail trade, manufacturing sales, building permits and employment data in the 10 provinces - has sharply accelerated, pointing to a continued rise in GDP growth (Chart I-15). Chart I-14Canada Is Booming And Slack Is Shrinking A Soft-Spoken Yellen A Soft-Spoken Yellen Chart I-15Strong Data Across The Board Strong Data Across The Board Strong Data Across The Board USD/CAD continues to trade at a discount to real interest rate differentials, signaling further upside on the CAD. Also, while investors have begun to curtail their shorts on the loonie, there do remain enough stale shorts for the CAD advance to persevere. We continue to prefer playing the CAD's strength on its crosses such as versus the AUD and the EUR, as the risk profile seems cleaner on these pairs than versus the USD. Short EUR/CAD looks particularly attractive. Our long CAD/NOK trade is near its target, and we are closing this position. Bottom Line: The Bank of Canada has not only hiked rates, but it has also highlighted that the Canadian economy is strong and inching closer to full capacity. The market has taken note, with the loonie rallying violently. The CAD has more upside going forward, especially against the euro and the AUD. We are booking profits on our long CAD/NOK position. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see European Investment Strategy Special Report titled, "Fractals, Liquidity & A Trading Model", dated December 11, 2014, available at eis.bcaresearch.com 2 Please see Foreign Exchange Strategy And Global Alpha Sector Strategy Special Report titled, "Who Hikes Next?", dated June 30, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 The greenback has largely been flat this week, despite Yellen's statements regarding rate hikes and balance sheet normalization at her Congressional Testimony, even if, 10-year yields went down. U.S. economic data has a soft tone: NFIB Business Optimism Index came in lower than expected at 103.6, reflecting broad-based softness in the details of the survey; JOLTS job openings also came in lower than expected at 5.666 mn; Initial jobless claims underperformed expectations, coming in at 247,000; Additionally, continuing jobless claims were higher than expected at 1.945 mn. While data remains mixed, the Fed is still intent on tightening policy. The dollar will follow suit, especially if inflation moves as the Fed expects. Report Links: Who Hikes Next? - June 30, 2017 Look Ahead, Not Back - June 9, 2017 Capacity Explosion = Inflation Implosion - June 2, 2017 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Data out of Europe this week was reasonably strong: Both exports and imports increased at a 1.4% and 1.2% monthly pace, respectively; The current account beat expectations; Industrial production increased by 4%, more than the expected 3.6%; However, despite this upbeat data, the euro remained largely flat this week. This behavior is justified from a technical perspective: the RSI is close to overbought levels; the MACD line is rolling over and closing the gap with the signal line; the number of speculators with long positions is at its highest level ever. The considerable weakness in EUR/SEK and EUR/NOK on Thursday shows underlying weakness in the euro. This decreases the likelihood that EUR/USD breaches the 1.15-1.16 zone. Report Links: Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 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: Labor cash earnings yearly growth outperformed expectations and grew from last month, coming in at 0.7%. However, machinery orders yearly growth was far below expectations, coming in at 0.6%. In spite of the selloff in the dollar, USD/JPY has rallied by more than 1% since last week, stopping its ascent after hitting a key technical level at 114.5. We continue to be yen bears, even in the face of the declining popularity of Shinzo Abe: the champion for expansionary fiscal policy in Japan. Instead, we are confident that Abe will double down on fiscal spending as his decline in popularity has been precisely because he has strayed away from this key policy pillar which made him so popular. Report Links: Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 Updating Our Intermediate Timing Models - April 28, 2017 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. has been mixed: Halifax House prices grew by only 2.6% YoY, underperforming expectations of 3.1%. Industrial Production contracted by 0.2% year-on-year, also underperforming expectations. While the unemployment rate decreased, coming in at 4.5% and also beating expectations, average earning growth fell to 1.8%. After appreciating by almost 2% this week, and reaching 0.895, EUR/GBP has come down to 0.885, but the pound is likely to have short term downside against the euro. Furthermore, GBP/USD is also likely to have downside, as the pound is not as attractive as it was in the beginning of the year from a valuation standpoint. Indeed, sentiment has turned much more positive on the outcome of Brexit, which means that the significant discount in the pound has disappeared. Report Links: Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 The AUD has seen a broad-based increase this week, except for against the CAD. This increase has largely been a factor of Chinese data, although domestic conditions also played a role: Chinese exports and imports both increased at a 11.3% and 17.2% annual pace, respectively; China's trade balance in June was USD 42.77 bn, better than expected; Chinese new loans came in at RMB 1,540 bn; NAB Business Conditions and Confidence both beat expectations; However, investment lending for homes is still contracting at 1.4%, albeit at a lesser than expected pace of 2.3%; Also, home loans are increasing at a lesser than expected pace of 1%. We retain our view of the inherent weakness in the Australian economy, which will restrict the RBA from changing its view. This will weigh on the AUD in the near future. Report Links: Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 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 AUD/NZD has rallied by almost 1.3% since last week. This in part, was the market reaction to an approved housing infrastructure fund by Prime Minister Bill English worth NZ$1 Billion aimed at increasing the supply of housing in the country. This measure provides the RBNZ with some breathing room, as it is a policy aimed at cooling housing market, which has prices growing at a 14% rate. The increase in housing supply alleviates the pent up demand generated by the dramatic increase in population in New Zealand in recent years. The RBNZ is unlikely to join the BoC and the Fed this year, as they remain cautious, and have opted for macro prudential measures to eliminate any imbalances in the economy. Stay short the NZD against the dollar and the yen. Report Links: Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Canada followed the footsteps of its partner in the south, joining the U.S. as the only two central banks in the G10 space raising interest rates. The Bank of Canada highlighted that "the adjustment to lower oil prices is largely complete" and that "both the goods and services sectors are expanding". Alberta's economy validates this stance as all sectors of the economy are growing at a very brisk pace. The BoC estimates that the output gap will now close at the end of 2017, instead of the previous forecast of the first half of 2018, further escalating their hawkish rhetoric. The press release noted that the recent restrain in inflationary pressures will be transitory, as "excess capacity is absorbed". Recent data corroborates this view with strong employment data and stronger than expected housing starts. USD/CAD declined 1.3% at the end of the day of the hike, and outperformed all other currencies. Report Links: Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 Exploring Risks To Our DXY View - May 26, 2017 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland has been mixed: Unemployment remains very low, coming in at 3.2% However, producer and import prices contracted by 0.1% year-on-year, coming below expectations and decreasing from the previous month. The low unemployment number is not the only indicator that shows a tight labor market, as employment is also growing at an astonishing 5% yearly rate. However, this tightness in the labor market is not translating to higher wages, as wages are growing at a paltry 0.6%, anchored by strong deflationary forces. Thus, the SNB will continue with their ultra-dovish monetary policy and with their interventions in the currency market. Nevertheless, we will monitor if the recent plunge in the CHF against the euro creates any kind of inflationary dynamics in the economy, and causes the SNB to rethink their stance. Report Links: Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway has been mixed: Manufacturing output contracted by 0.3%, falling sharply from last month number. Additionally, although both core and headline inflation came above expectations at 1.6% and 1.9% respectively, they still fell from last month reading. The Krone has appreciated sharply the past week, with USD/NOK falling by 1.45% and EUR/NOK falling by 1.15%. This has been a result of the rebound in oil prices caused by the massive draws in inventories the past couple of weeks. Indeed, last week's number, which showed an inventory draw of 7.6 million barrels was the biggest since 2011. Overall, we expect that OPEC should be able to continue managing supply, and therefore, oil should rise until the end of the year. This will be negative for EUR/NOK. Report Links: Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 Exploring Risks To Our DXY View - May 26, 2017 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 The Riksbank's change in rhetoric was perfectly timed, as Sweden's economy is increasingly showing signs of strength. Data has outperformed these past two weeks: Manufacturing PMI came in at 62.4, beating expectations of 59.8; Industrial production increased at a 8% annual pace in May; Inflation in Sweden is firming, coming in at 1.7% in June and beating expectations. The SEK appreciated 0.7% against EUR, and 0.6% against USD. Markets are pricing in stronger growth and a further escalation of hawkish rhetoric from the central bank, especially as Stefan Ingves as tabulated to leave this Riksbank in a few months. Part of the reason for Sweden's strength is also a stronger European economy. With Germany leading the pack, Sweden's largest export partner is also lifting the largest Scandinavian economy. Report Links: Who Hikes Next? - June 30, 2017 Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Coordinated Hawkishness: Central bankers are in the process of taking back the easier monetary policy that followed the deflationary 2014/15 oil shock. Bond yields still have more upside to catch up to the solid pace of global growth and diminishing economic slack. Maintain a below-benchmark stance on overall portfolio duration. ECB Taper Tantrum: The recent European bond sell-off is following a similar pattern to both the 2013 Fed Taper Tantrum and the 2015 Bund Tantrum, suggesting a potential target of 1% on the benchmark 10-year German Bund yield by year-end. Stay underweight Euro Area government bonds. Canada: With the Canadian economy looking very strong, and with the Bank of Canada signaling a desire to begin normalizing monetary policy, the current underperformance of Canadian government bonds will continue. We are maintaining our tactical bearish positions on Canadian bonds, and are also adding a new strategic underweight position (2 out of 5) in our model bond portfolio. Feature A Regime Shift, Not A Regime Change Interest rate risk has returned with a vengeance in global fixed income markets over the past couple of weeks. A string of relatively hawkish policymaker comments has triggered a quick and sharp bond sell-off, as investors reprice the odds of what is looking now like a coordinated recalibration of global monetary policies. Longer-dated bonds have gotten pummeled as yield curves have bear-steepened in most countries, with 30-year government bond prices falling between -5% and -7% in a matter of days (Chart of the Week). With global growth looking very strong at the moment, policymakers are being forced to respond by looking to unwind some of the easing that took place after the crash in oil prices in 2014/15. With that deflation scare now firmly in the rearview mirror, central bankers are having to signal a move away from the emergency stimulus from 2015. The rapid yield responses seen so far suggest that the communication of that subtle policy shift - becoming "less dovish" rather than "more hawkish" - must be handled delicately, or else financial markets may riot and possibly short-circuit the current economic upturn. This yield surge has done very little to dampen investor enthusiasm for risk assets, so far. Equity prices and corporate credit spreads, both in the developed world and emerging markets (EM), have only moved modestly despite the large move in government bond yields (Chart 2). This suggests that the latter was most mispriced compared to the current solid pace of global economic growth. Chart of the WeekA Painful Repricing A Painful Repricing A Painful Repricing Chart 2Risk Assets Remain Unfazed Risk Assets Remain Unfazed Risk Assets Remain Unfazed With the benefit of hindsight, it now appears that the decline in global bond yields in the spring was an outsized response to a few below-consensus data prints on U.S. economic growth and inflation. Importantly, the numbers in the U.S. are starting to improve again, as indicated by the strong jump in the ISM indices and employment (+220k) in June. Many of our most reliable leading indicators and models are all pointing to further acceleration in U.S. growth in the next few quarters (Chart 3). The U.S. inflation data continues to disappoint, both in terms of price indices and wage growth. Growth in Average Hourly Earnings has drifted lower since the most recent peak, while core PCE inflation is only 1.4%. The latest commentary from the Fed, including the minutes from the June FOMC meeting released last week, suggests that this downdraft in inflation should prove to be temporary and stronger growth should lead to faster inflation. We would agree with that assessment. The U.S. unemployment rate at 4.4% remains below most measures of full employment, while other reliable indicators of labor market tightness, such as the spread between the "jobs plentiful" and "jobs hard to get" components of the U.S. consumer confidence report, are also pointing to an eventual reacceleration of wages (Chart 4, top panel). Meanwhile, the Cleveland Fed Median CPI is hovering around 2.5%, well above the current 5-year/5-year forward cost of inflation compensation embedded in U.S. TIPS prices of 1.83% (middle panel). Furthermore, the Phillips Curve based core PCE inflation model developed by our colleagues at U.S. Bond Strategy is signaling a rebound of core PCE inflation back above 1.9% by year-end, in a scenario of no change in the unemployment rate or U.S. dollar from current levels (bottom panel). Chart 3U.S. Growth Will Rebound U.S. Growth Will Rebound U.S. Growth Will Rebound Chart 4U.S. Inflation Will Rise U.S. Inflation Will Rise U.S. Inflation Will Rise Our base case scenario for the Fed is that additional tightening will come in 2017. First through an announcement on starting the process of reducing the Fed's balance sheet, through "tapering" the reinvestment of proceeds from maturing bonds held by the Fed, at the September FOMC meeting. After that, the next rate hike will not be until December. This will allow the Fed to see more inflation prints to confirm its own expectation that inflation will soon rebound before delivering more policy tightening. Of course, if the next couple of inflation releases surprise to the upside, then perhaps a rate hike is possible at the September meeting alongside the announcement on the Fed's balance sheet (which is basically a done deal, at this point). For now, we see the Fed staying cautious, especially given the increasing number of FOMC members who are becoming concerned with the lack of U.S. inflation, according to the June minutes. As for the other major developed economy central banks, this "old-school" cyclical upturn is boosting both capacity utilization and pipeline inflation (Chart 5). Combined with the other measures that have been showing diminished economic slack, like unemployment rates and output gaps, this will give policymakers confidence in their own medium-term growth and inflation forecasts. This will also embolden central bankers to remove some policy accommodation. Our own Central Bank Monitors are indicating a need for tighter monetary policy in every major developed economy except Japan. That is confirmed by Taylor Rule estimates for interest rates. In Chart 6, we present simple Taylor Rule projections for the policy rate in the U.S., Euro Area, U.K., Japan, Canada and Australia. The formula takes potential GDP growth (OECD estimates) and then adds current realized inflation, ½ of the deviation of inflation from the central bank target and ½ of the output gap.1 We also show projections for the Taylor Rule over the next two years, using individual central bank forecasts for inflation and IMF projections for potential growth and the output gap. We then compare those Taylor Rule forecasts with the rate expectations priced into Overnight Index Swap (OIS) curves. Chart 5An "Old-School" Cyclical Upturn An "Old-School" Cyclical Upturn An "Old-School" Cyclical Upturn Chart 6Rates Too Low, According To The Taylor Rule Rates Too Low, According To The Taylor Rule Rates Too Low, According To The Taylor Rule The first point to note is that policy rates are below the Taylor Rule "equilibrium" level everywhere except Japan, where the 0% interest rate looks appropriate given the lack of actual inflation. Secondly, the Taylor Rule rates are projected to rise in the U.S., Euro Area, Japan and Canada, while remaining around current levels in the U.K. and Australia. Thirdly, the projected rates using Taylor Rule estimates are well above the current path of rates discounted in OIS curves. We do not expect central banks to deliver anywhere near the amount of tightening suggested by these simple Taylor Rules over the next couple of years. Policymakers will likely tolerate some degree of higher realized inflation to ensure that inflation expectations can return to, and sustainably stay at, central bank target levels. This means keeping interest rates below equilibrium levels for as long as possible. However, if central banks believe their own current inflation forecasts (which we have used in our Taylor Rule estimates), then policy rates do have room to move higher without becoming restrictive (i.e. above the Taylor Rule estimates). The markets clearly disagree with these Taylor Rule projections, with much lower OIS rates expected in the next few years. The markets may turn out to be correct. At the moment, however, the gap between the Taylor Rule rate forecasts and market pricing is too large, which suggests there is additional scope for bond yields to rise. Even if central banks ignore their own forecasts of higher inflation and keep rates on hold, this will put upward pressure on bond yields via higher inflation expectations. In other words, the path of least resistance for bond yields is up - at least until there is a major financial market event, like a big pullback in equity prices or widening of corporate bond spreads. Yet until there is evidence that global growth is rolling over and decelerating, a "risk-off" event like that is unlikely. Investors should maintain below-benchmark duration exposure, and overweight allocations of corporate debt to government bonds, in the next 3-6 months. Watch the path of leading economic indicators before looking to reverse those positions. Bottom Line: Central bankers are in the process of taking back the easier monetary policy that followed the deflationary 2014/15 oil shock. Bond yields still have more upside to catch up to the solid pace of global growth and diminishing economic slack. If It Walks Like A Tantrum And Talks Like A Tantrum ... The spike in Euro Area bond yields since June 26th has raised concerns that another bond "tantrum" is unfolding, similar to U.S. Treasury sell-off in 2013 and the German Bund sell-off in 2015. In both cases, bond yields jumped rapidly as investors repriced the outlook for central bank policy. The recent comments from the European Central Bank (ECB) are signaling that a change in its asset purchase program, which is set to end on December 31st, is highly likely and were the trigger for the backup in European yields. We have already shown in previous reports how the benchmark 10-year German Bund yield has been following the same directional path as the 10-year U.S. Treasury yield in the months leading up to the 2013 Taper Tantrum.2 We benchmarked the two markets for the peak in our Months-to-Hike indicator for the timing of the first rate hike priced into OIS curves. In Chart 7, we show the same comparison for the various slopes of yield curves for U.S. Treasuries and German government bonds. Again, the German curve is following the Fed Taper Tantrum experience, which implies more bear-steepening pressure on yields over the rest of 2017. In Chart 8, we show a similar "cycle-on-cycle" comparison of German bonds today compared to the spring of 2015 during the Bund Tantrum episode. That sell-off took place over a much shorter time horizon than the U.S. Taper Tantrum, with the entire sell-off condensed to just over a month. The current backup in German yields looks to be following a similar pattern to the Bund Tantrum, suggesting that this move could take the benchmark 10-year yield back to 1% before it is done. Chart 7Taper Tantrum 2.0?... Taper Tantrum 2.0?... Taper Tantrum 2.0?... Chart 8...or Bund Tantrum 2.0? ...or Bund Tantrum 2.0? ...or Bund Tantrum 2.0? There are major differences between today and the 2015 episode - European economic growth is much faster, the output gap is narrower, and realized inflation is higher than it was two years ago (bottom two panels). The 2015 Tantrum was triggered by two events: a rise in European inflation back above 0% that led to a (misguided) belief among investors that the ECB, which had just started its asset purchase program, would quickly look to exit that program; a massive unwind of long positions in core European bond markets, made worse as speculators who were betting on a reversal of the initial jump in Bund yields got stopped out as yields continued to climb. Roll the tape to 2017, and the growth and inflation backdrop is much different. Now, the ECB is indeed talking openly about exiting/tapering its asset purchase program, supported by a solid European growth backdrop. There is likely less speculative positioning in European markets given the painful experience of the Bund Tantrum. However, with the ECB now owning significant shares of European bonds after two years of steady buying, the potential for a jump in yields driven by less-liquid markets may still be there. Net-net, the current Bund sell-off has additional upside when compared to the previous Tantrums, suggesting the Bund yield could rise to 1% before this move is done. Watch the performance of European equities and the euro for signs that the pain trade in Bunds could stall before 1%. If equities break lower or the Euro breaks higher (or both), the ECB commentary about the timing of a taper could take a more dovish turn. This is not our base case, though. Bottom Line: The recent European bond sell-off is following a similar pattern to both the 2013 Fed Taper Tantrum and the 2015 Bund Tantrum, suggesting a potential target of 1% on the benchmark 10-year German Bund yield by year-end. Stay underweight European government bonds. Move To An Underweight Stance On Canada This week, the Bank of Canada (BoC) meets to determine the next move for Canadian monetary policy. For the first time since 2010, that move will likely be a rate hike. The Canadian economy is booming, and the strength is starting to bump up against capacity constraints. The strong performance of real GDP growth in Q1 (+3%) looks to be followed up by a similar growth rate in Q2. The BoC's latest 2017 Business Outlook Survey made for great summer reading, as expectations for sales, capital spending and employment all remained quite strong (Chart 9). Firms were reporting that an increasing share of capital spending intentions were for the purposes of increasing capacity to accommodate stronger demand, a sign that Canadian businesses are becoming more optimistic that the economic upturn is sustainable. Hiring intentions hit the highest level ever recorded in the Survey, with firms also reporting an increase in employment to meet up with stronger demand. Current Canadian inflation rates remain subdued, but a pickup in output prices is expected over the next 12 months according to the Business Outlook Survey (bottom panel). A net positive number of respondents reported capacity constraints and labor shortages for the first time in the three years that those questions have been asked as part of the Survey. The BoC's growth forecasts are clearly too low and will likely be revised upward at this week's policy meeting, when a new Monetary Policy Report will be presented. This will likely be the reason for a rate hike to either be delivered this week, or strongly hinted at for the next policy meeting. Given the recent comments from BoC Governor Stephen Poloz and other BoC officials discussing the improving health of the economy and the need to "take back" the 50bps of rate cuts in 2015 as oil prices were collapsing, a rate hike is the more likely outcome this week. Already, the markets have moved to price in a more hawkish BoC, with a full 75bps of hikes expected over the next 12 months. This has helped out bearish Canadian rates trades in our Tactical Overlay Portfolio (see Page 15 and Chart 10), which were positions that benefitted from a stronger Canadian economy and more hawkish BoC. With Canadian policy rates still well below equilibrium (see our Taylor Rule estimates shown earlier), and with leading economic indicators still pointing towards accelerating Canadian economic growth in the coming quarters, the case for the BoC to leave rates at these current depressed levels is not a strong one. Chart 9A Robust Canadian##BR##Growth Upturn A Robust Canadian Growth Upturn A Robust Canadian Growth Upturn Chart 10Sticking With Our Winning##BR##Tactical Canadian Trades Sticking With Our Winning Tactical Canadian Trades Sticking With Our Winning Tactical Canadian Trades We see the recent underperformance of Canadian government bonds as the start of a more prolonged trend, thus we are opening up a new strategic position in our model bond portfolio: cutting our Canada country allocation to underweight (2 out of 5). As Canada is only a small part of our benchmark index (only 1%), we are increasing our U.S. exposure as an offset to our lower Canadian weighting. This will not change our below-benchmark allocation to U.S. Treasuries, while making our new position a more explicit bet on additional widening of the Canada-U.S. bond spread. Chart 11Canada Rates Strategy Summary:##BR##Move To Underweight Canada Rates Strategy Summary: Move To Underweight Canada Rates Strategy Summary: Move To Underweight If the economy improves enough to continue absorbing economic slack and put upward pressure on inflation, both realized and expected, then the potential for higher Canadian yields and a flatter Canadian curve - as the BoC becomes even more hawkish - will also increase (Chart 11). One huge caveat to this trade is the state of the Canadian housing market. Even a small move in policy interest rates could have a huge impact on the demand for Canadian housing and the health of Canadian household finances. A recent private-sector survey showed that 70% of Canadian homeowners could not manage even a 10% rise in their interest payments.3 Given the extreme valuations in the Canadian housing market, and some of the recent macro-prudential measures taken to deter speculation in the booming Vancouver and Toronto markets, there is potential for a larger housing downturn after a few BoC rate hikes. This will not prevent the BoC from normalizing rates, but if the housing market responds poorly and there is a spillover into concerns about the state of Canadian banks, then any backup in Canadian bond yields will be short-lived. This is a risk and not our base case over the next year, however. Bottom Line: With the Canadian economy looking very strong, and with the Bank of Canada signaling a desire to begin normalizing monetary policy, the current underperformance of Canadian government bonds will continue. We are maintaining our tactical bearish positions on Canadian bonds, and are also adding a new strategic underweight position (2 out of 5) in our model bond portfolio. Tactical Trade Update We have been recommending a position in our Tactical Overlay Table since March to position for additional Fed rate hikes, shorting the January 2018 fed funds futures contract. That contract is now priced for the fed funds rate to increase 15bps between now and the end of the year. Given that even an optimistic economic scenario would likely only result in one more 25bp increase in the funds rate by year-end, there is no longer much potential for further gains in this trade. We are closing the position this week, taking a tiny profit of +1bp. Chart 12Roll Our Short Fed Funds##BR##Futures Trade To July 2018 Roll Our Short Fed Funds Futures Trade To July 2018 Roll Our Short Fed Funds Futures Trade To July 2018 Looking further out, we now see an attractive new opportunity to short the July 2018 fed funds futures contract. That contract is currently priced for only 32bps of rate hikes between now and next June (Chart 12), and would therefore turn a profit in the event of two or more rate hikes during that timeframe. We are opening the new trade today, shorting the July 2018 contract. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 We show the inflation gap as the difference between realized inflation and the inflation target, using the actual inflation rate that the central bank is targeting. This could be headline inflation, as in the U.S. and Euro Area, or core inflation, as in Japan. 2 Please see BCA Global Fixed Income Strategy Weekly Report, "Central Banks Are Now Playing Catch-Up", dated July 4 2017, available at gfis.bcaresearch.com. 3 http://www.newswire.ca/news-releases/the-debt-truth-unexpected-expenses-could-spell-big-trouble-for-millennial-homeowners-623825354.html Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Dangerous Duration Dangerous Duration

Highlights EM equity breadth has moved into negative territory, DM-based excess liquidity measures are set to roll-over, and China-based liquidity measures are also weak. Individually, each of these factors are not enough to raise alarm bells, but together they point to a period of heightened risks for EM assets and commodity currencies. AUD/CAD and NZD/JPY are set to suffer in this environment. EUR/USD will rise to 1.15-1.16, but unlike in 2015, it should not receive much of a fillip from EM volatility. Feature Chart I-1Technical Risk In EM Technical Risk In EM Technical Risk In EM An interesting development has unfolded in emerging markets. While the pause in the EM rally has hit investors' radar screens, the more puzzling event concerns breadth. Not only has the advanced/decline line rolled over, but more worrisomely, it has recently moved into negative territory. Historically, when more stocks are declining rather than advancing, EM equities tend to experience sharp selloffs (Chart I-1). This development is important when put into a global context. EM stocks and related assets like commodity currencies have been buoyed by plentiful global liquidity conditions. However, global liquidity is set to deteriorate. A rocky second half may emerge in EM assets. Global Liquidity Is Slowing Following in the Federal Reserve's footsteps, DM central banks are moving away from monetary accommodation. Last week, European Central Bank President Mario Draghi made a speech that was interpreted as representing an abandonment of the ECB's dovish bias. With the anticipation that its bond-buying program will be tapered early in 2018 and reports that the ECB is having problems buying its quota of German and Finnish bonds, global bonds suffered, with Bund and T-Note yields moving up 33 and 23 basis points since June 27, respectively. The ECB is not the only central bank to have changed its tack. The Bank of Canada's communications have been crystal clear that it intends to increase rates this summer, or early fall at the latest. Even the perennially dovish Riksbank is moving away from its easy bias, as Sweden's resource utilization points to a continued acceleration in core inflation. But does this even matter? The global economy is strong, and beginning to remove accommodation is not quite the same thing as pushing rates into tight territory. The advanced economies are unlikely to suffer much from this development. However, the picture for EM is more concerning. Some key leading indicators of EM activity have already begun to roll over. For example, Taiwanese IP, a key bellwether of overall EM strength, is now contracting on a year-on-year basis (Chart I-2, top panel). Meanwhile EM PMIs rolled over three months ago and EM narrow money growth, a key forecaster of EM profits, is slowing sharply (Chart I-2, bottom panel). Despite these negative developments, EM stocks have remained resilient. The factor underpinning this impressive performance has been the rise in global liquidity. More technically, the rise in the global Marshallian K - the ratio of money to nominal GDP - over the past six months. Excess money has had to go somewhere. Among the many refuges, EM has been a key pole of attraction, with massive inflows supporting assets prices. The 8% appreciation in EM currencies versus the dollar since their January 2016 trough has been a vivid illustration of this phenomenon. The driver of the rise in excess money has been the ratio's numerator, dollar-based liquidity. The Fed's various QE programs were key determinants of dollar-based liquidity (Chart I-3). However, its tapering in late 2014 was enough to prompt a contraction of the measure. Now that the Fed is intent on decreasing its balance sheet while the ECB tapers and other smaller DM central banks begin increasing rates, the small improvement witnessed in the past three months is likely to end. The recent weakness in gold prices, despite the softness in the dollar, could be a sign that markets are beginning to sniff out the imminent tightening of global liquidity conditions. Chart I-2EM/China Profits Growth To Roll Over (I) EM Growth ##br##Has Deteriorated, Profits Will Suffer EM/China Profits Growth To Roll Over (I) EM Growth Has Deteriorated, Profits Will Suffer EM/China Profits Growth To Roll Over (I) EM Growth Has Deteriorated, Profits Will Suffer Chart I-3The Fed Balance Sheet Runoff ##br##Will Hurt Global Liquidity The Fed Balance Sheet Runoff Will Hurt Global Liquidity The Fed Balance Sheet Runoff Will Hurt Global Liquidity Additionally, not only are global central banks, led by the Fed, tightening or looking to tighten policy, they are doing so despite an absence of actual inflation. As a result, this means DM real yields are set to rise. As Chart I-4 illustrates, rising real DM yields have historically been a harbinger of poor EM bond performance. In fact, the action in DM real yields since mid-2016 already points to a problematic second half for EM bonds. As a result, EM bond investors are likely to suffer some losses in the coming months. Such losses would not only tighten EM financial conditions, but would also be symptomatic of capital leaving the region. Less money in those markets simply means less liquidity. With EM corporate spreads near historical lows, a repricing of credit risk on the back of softening global and EM liquidity is likely to prompt both a selloff in EM stocks and in EM currencies (Chart I-5). As a result, DM commodity currencies, the NZD and AUD in particular, could suffer. Chart I-4EM Financial Conditions##br## Are Set To Deteriorate EM Financial Conditions Are Set To Deteriorate EM Financial Conditions Are Set To Deteriorate Chart I-5If Liquidity Dries, Spreads Widen ##br##And EM Stocks Fall If Liquidity Dries, Spreads Widen And EM Stocks Fall If Liquidity Dries, Spreads Widen And EM Stocks Fall Bottom Line: In November 2016, a new leg of the EM rally began - a move driven by an expansion in global liquidity, even as a key bellwether of EM economic activity rolled over in the interim. Global excess liquidity is set to roll over as DM central banks abandon their dovish biases and the Fed begins to let its balance sheet run off. With EM weaker from a technical perspective, the second half of 2017 could be a tough environment for EM plays. Chinese Liquidity Joins The Fray In May 2015, EM equities in U.S.-dollar terms peaked just before global liquidity began to roll over. Compounding the risks, back then Chinese economic conditions were also problematic. Excess capacity and massive deflationary forces were wearing down on profits and investment. China is thus another key factor to watch. In this optic, beyond DM liquidity, a key driver of the rebound in EM last year was actually Chinese liquidity conditions. In the second half of 2015, China's own Marshallian K - based on M2 relative to nominal GDP growth - was rebounding sharply, as the PBoC was easing policy and the fiscal authorities were pressing on the gas pedal, expanding both public expenditures and pushing credit growth through the economy. However, that was then. Today, China has joined the tightening party. The quarterly moving average of Chinese interbank rates has increased by 100 basis points over the past year. Crackdowns on real estate and excess leverage have also resumed. Most importantly, the issuance of bonds by small and medium banks - a key source of grease to total social financing - has also massively decelerated, which points to a sharp slowdown and even a contraction in the Chinese credit impulse (Chart I-6). Thanks to this development, the Chinese Marshallian K is now in negative territory. The global impact of tighter Chinese monetary conditions is also flashing a red flag. Our indicator is based on the relative performance of Chinese bank stocks and USD/HKD. Underperformance of Chinese banks tends to send warning signs that tightening policy is beginning to negatively affect the outlook for Chinese credit growth. Additionally, USD/HKD is at an 18-month high because Hong Kong interest rates have not been able to follow U.S. ones, as loan demand by mainland-China entities has been poor. Most of the time, this indicator tends to move with EM stock prices, providing very little information. However, as Chart I-7 illustrates, this gauge is at its most useful when it diverges from EM equity prices. In each case, such as in 2007, 2011, and 2014, the divergences between the falling price-based Chinese liquidity indicator and rising EM stock prices was resolved by a correction in the latter. Today, the indicator points to a large amount of downside risk for EM stocks. Chart I-6Chinese Credit Impulse Will Slow Chinese Credit Impulse Will Slow Chinese Credit Impulse Will Slow Chart I-7A Worrying Divergence A Worrying Divergence A Worrying Divergence Again, it is important to reiterate that in and of itself, such a divergence is not enough to prompt investors to run for the hills and ditch EM stocks and related plays. However, when this happens as DM liquidity is also set to deteriorate, and most crucially, when EM breadth turns negative, decreasing EM exposure makes sense. Bottom Line: Chinese liquidity conditions are also deteriorating. The People's Bank of China may not want to push the economy into another slowdown cycle, which will most likely limit how far the Chinese central bank will tighten policy. However, this tightening has not been priced in by EM equities, and is happening as DM central banks are also reducing accommodation and as EM breadth has greatly deteriorated. A sizeable correction in EM plays is becoming increasingly likely. Investment Implications Chart I-8Global Liquidity Leads EM ##br##By More Than A Year Global Liquidity Leads EM By More Than A Year Global Liquidity Leads EM By More Than A Year A tightening of dollar-based liquidity and Chinese-based liquidity is a big problem for non-China EM economies. EM economies outside of China and OPEC nations still run an annual current account deficit of more than US$200 billion. They need liquidity. Moreover, they still have at least US$3.6 trillion in foreign-currency debt. With liquidity conditions deteriorating, we should expect a widening of EM spreads, falling EM stock prices and falling commodity currencies. In fact, we are today in the window of maximum risk. Chart I-8 shows the combined G7 and Chinese Marshallian K, standardized. This indicator tends to have long leads over EM equity prices. It turned negative in the summer of 2006, though EM stock prices did not peak until the fourth quarter of 2007. It turned negative again in the early days of 2010, but EM equity prices did not peak until April 2011. The indicator moved below zero in mid-2014, yet EM equities only sold off in the second quarter of 2015. This time around, the combined liquidity indicator became negative in early 2016, suggesting great risks for EM assets and related plays in the second half of 2017. High carry EM currencies like the BRL or the TRY are at risk. The ZAR looks especially poorly positioned as well but the RUB seems better cushioned against these risks. The MXN could suffer too as Mexico has a lot of U.S. dollar-denominated debt. Nonetheless, MXN remains much cheaper than the BRL and could still outperform its Brazilian brethren. The SGD is very sensitive to global liquidity conditions, as Singapore is a key banking center for EM, and could also suffer substantially against the USD. In terms of timing for the G10 currency markets, the deterioration of EM breadth has historically been a dangerous sign for commodity currencies (Chart I-9). This combination of deteriorating liquidity and breadth is often associated with a sharp selloff in NZD/JPY (Chart I-10). Investors should short this cross, and we are re-opening this trade this week. Chart I-9Commodity Currencies##br## Prefer A Fresh Breadth... Commodity Currencies Prefer A Fresh Breadth... Commodity Currencies Prefer A Fresh Breadth... Chart I-10...So Does ##br##NZD/JPY ...So Does NZD/JPY ...So Does NZD/JPY The dynamics highlighted above also explain why despite our positive stance on Canada and the CAD, we are not willing to chase the selloff in USD/CAD further, and prefer to play the CAD's strength through its crosses. The risk-reward ratio seems better this way, as we are not as negatively exposed to an EM selloff as we would be buying the CAD against the USD. Indeed, a cleaner way to play the BoC's change of tone while gaining exposure to an EM-risk off theme, is to short AUD/CAD, a trade that is already on our book. On the domestic front, this week the Reserve Bank of Australia disappointed markets and did not try to indicate a change in stance away from its dovish bias. Markets have taken notice, with the AUD incapable of rallying against a weak USD, despite very strong trade data yesterday. Meanwhile, the BoC is telegraphing a rate hike in the very near future. Additionally, an abnormal gap has emerged between AUD/CAD and AUD/USD. As Chart I-11 shows, historically, AUD/CAD and AUD/USD have tracked one another. This makes sense. The Australian economy is very levered to Asian growth and liquidity dynamics, while Canada is a crucial link in the North American supply chain. With the U.S. and Canadian business cycles so tightly integrated, the CAD tends to mimic the greenback when compared to non-USD currencies. Chart I-11AUD/CAD Is A Short AUD/CAD Is A Short AUD/CAD Is A Short The points in time when AUD/CAD has been much stronger than the AUD/USD deserve closer attention. They are periods of booms in EM Asia, such as the middle of the 1990s, or 2004 to 2005. Today, AUD/CAD is again out of line with AUD/USD, reflecting the boom in EM assets prices in 2016 and in the first half of 2017. However, if our view is correct that EM is entering a dangerous zone, AUD/CAD should weaken further. Chart I-12When Investors Are Short, ##br##EUR/USD Likes EM Selloffs When Investors Are Short, EUR/USD Likes EM Selloffs When Investors Are Short, EUR/USD Likes EM Selloffs Last but certainly not least the euro. EUR/USD has much momentum and could continue to rally into the 1.15-1.16 zone. In fact, historically, EM shocks have been able to lift the euro, albeit temporarily. This definitely was the case in 2015 when EM sold off: in April 2015, when EM began to weaken, in August 2015, when a temporary selling climax emerged after the Chinese floated the CNY, and in December 2015, after the Fed hiked. The euro spiked in all three instances. However, investors were very short EUR/USD entering each of these periods, and the ensuing rallies were short-covering rallies (Chart I-12). This time around, investors are very long the euro, suggesting that the euro has not been used as a funding vehicle to the same extent as it was in 2015. Additionally, in all these previous episodes, EUR/USD traded at a small discount to the fair value implied by real rate differentials, today it is trading at a premium. Thus, the same kind of short-covering rally is unlikely. As a result, we do not anticipate EUR/USD to break out of its range on the back of an EM risk-off event. That being said, EUR could outperform GBP in this type of environment. The pound remains very dependent on global liquidity conditions to finance its current account deficit of more than 4% of GDP. With big financial institutions announcing more divesture from the U.K., these hot-money flows could prove even more crucial. As a result, we are removing our call to short EUR/GBP if it moves above 0.88, and expect a move in EUR/GBP toward 0.92-0.93 in the second half of 2017. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@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 The greenback slipped on weak as the ADP employment, the ISM-non manufacturing employment component, and continuing as well as initial jobless claims all underperformed expectations. While the dollar reacted negatively to this news, the Fed's hawkish stance should ultimately help the USD. Supplementing the increases in interest rates, are plans to reverse the multi-year quantitative easing program.The FOMC is also increasingly worried about the "quite high" stock valuations which, could lead to financial instability. U.S. 10-year yields have gone up 4 basis points following the release of the minutes, after the 20 bps spike following initial Fed comments on June 27. Report Links: Who Hikes Next? - June 30, 2017 Look Ahead, Not Back - June 9, 2017 Capacity Explosion = Inflation Implosion - June 2, 2017 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 The euro's strength extends as the union experienced strong services and composite PMI measures this Wednesday. While it is true that the ECB may be looking to draw back its excessively easy monetary policy, Draghi and Praet have highlighted that accommodative policy is still needed as inflationary pressures are not yet entrenched. The euro's recent appreciation and weak producer price numbers could vindicate this view. The euro's strength has also weighed on manufacturing activity, as PMIs underperformed expectations. This is likely to weigh on EUR/USD going forward, especially as European stocks have been underperofming U.S. ones in recent weeks. EUR/SEK can face considerable pressure ahead due to the Riksbank's change in rhetoric. Report Links: Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 Europe's Divine Comedy Part II: Italy In Purgatorio - June 21, 2017 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: National inflation came in at 0.4%, while Tokyo ex fresh food and energy inflation contracted by 0.2%. Both of these measures underperformed expectations. On the other hand, Japan's job-to-applicant ratio continues to climb, coming in at 1.49, and outperforming expectations. This last data point is key, as it highlights that the Japanese labor market is very tight, and that the stage is set for inflation to come back to Japan. However, as evidenced by the recent disappointments in data, the currency holds the key to unleash inflation in Japan. Thus, not only is a selloff in the yen needed for inflation to remerge, but this selloff would feed on itself, as a falling currency and a tight labor market would raise inflation (and thus lower real rates, as Japanese 10-year rates are anchored at 0), which would push the yen down further. Report Links: Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 Updating Our Intermediate Timing Models - April 28, 2017 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. has been mixed: Markit manufacturing PMI declined from last month's reading and also came in below expectations at 54.3. Construction PMI also declined and came in below expectations at 53.4 However credit had a strong showing as net lending to individuals, consumer credit and mortgage approvals all came in above expectations at 5.3 billion pounds, 1.73 billion pounds and 65 thousand respectively. Various BoE members have stated that rising interest rates might be necessary to keep a lid on the island's high inflation. Although there are still some voices within the BoE who are more cautious, given the uncertainty that Brexit poses, overall the BoE has shown a much more hawkish tone in recent weeks. Report Links: Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 The AUD has experienced considerable weakness this week, following a drawback in inflation estimates for June by the TD Securities measure, of 2.3% from 2.8% and a less hawkish than anticipated RBA. While retail sales beat expectations of 0.2% - coming in at 0.6% - the pace of appreciation in the RBA Commodity Index in SDR terms continues to slow Nevertheless, these factors were not the only contributors to the recent AUD weakness. Australia remains highly levered to emerging markets, and the Fed tightening remains a major risk for the AUD. Report Links: Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand has been mixed: The annual trade balance underperformed expectations, coming in at a deficit of 3.75 billion U.S. dollars. However the ANZ business confidence index continued climbing, and now stands at the highest level in 8 months Overall the New Zealand economy continues to be one of the best performing in the G10. If one were to be guided merely by domestic factors, the RBNZ should be the next central bank to hike after the Fed. However the picture is slightly more nuanced, as the RBNZ is still worried about foreign developments, particularly EM weakness. This justifies why they continue to state that "monetary policy will remain accommodative for a considerable period". Thus, we continue to be bullish on the NZD against the AUD, while we are shorting it against the JPY, as a mean to benefit from a potential EM dislocation. Report Links: Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 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 broken down from a crucial technical level following Poloz's statements about the Canadian economy. He states that the "cuts have done their job". When asked about oil, the reply was reassuring, declaring that the expected level of WTI is at USD 40-50 bbl, which implies that fluctuations within that band should not influence movements the BoC path, helping the CAD in the process. He also suggested that "the adjustment we've been talking about... is largely complete now". While inflation is weak, the BoC governor highlighted that forward looking indicators for inflation should be monitored instead of current inflation. These variables are pointing to stronger growth, and are in line with the bank's expectations of a closing output gap in the first half of 2018. While this may be true, a strengthening CAD will remain a risk for inflation. Report Links: Who Hikes Next? - June 30, 2017 Exploring Risks To Our DXY View - May 26, 2017 Bloody Potomac - May 19, 2017 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland has been mixed: Although real retail sales yearly growth came in negative at -0.3%, it outperformed expectations and was better than last month. Additionally, the SVME PMI came also blew away expectations, increasing from last month's 55.6 reading to 60.1. However Consumer price inflation came in at -0.1%, underperforming expectations. The Swiss economy continues to be haunted by the ghost of deflation. Nonetheless, some economic indicators appear to be ticking up, most likely as a result of the sharp rally in EUR/CHF. We continue to believe that a rally of EUR/CHF beyond 1.1 is unlikely, as most of the good news in the euro area are already priced into the euro. Furthermore, any disappointments, particularly in EM could trigger a selloff in this cross. Report Links: Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 The Labor Force survey, which measures the number of unemployed people as a percentage of the total civilian labor force came in at 4.6%, increased since last month. This measure shows that despite the increase in oil prices the Norwegian labour market continues to be tepid. The Norges Bank agrees with our assessment, as it lowered its projected near term policy rate path. Furthermore, they projected that rates in Norway will not rise until the beginning of 2019. The reasons for this are two fold: first, inflation should continue to remain weak, as the pass through from the collapse in the currency has faded. Additionally, bubbly real estate prices, which were the only factor, which could incite the Norges Bank to become more hawkish, have gone down, following reform in lending standards. Thus, despite its good value, the NOK will continue to underperform amongst commodity currencies. Report Links: Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 Exploring Risks To Our DXY View - May 26, 2017 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 It is true that the Riksbank recently hinted towards a more neutral stance, acknowledging "that inflation has recently been slightly higher than expected", which has made it "less likely than before that the Riksbank will cut the repo rate in the near term". However, the Riksbank also highlighted the fact that the bank is "prepared to implement further monetary policy easing if necessary to stabilize inflation". A very nuanced statement referred to the exchange rate, which "is important that [it] does not appreciate too rapidly", further stating that "this could happen if, for example, the Riksbank's monetary policy deviates clearly from that of other countries." This conclusively highlights that the bank is wary of diverging rates lifting undesirably on the krona, which is a limiting factor for substantial krona strength in the near term. However, the change of guard at the helm of this central bank in early 2018 could change all this caution. Report Links: Who Hikes Next? - June 30, 2017 Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Feature Chart 1Global Growth Pick Up Global Growth Pick Up Global Growth Pick Up As a whole, G10 economies have been in expansion for more than seven years now. Moreover, after a near-recessionary episode in late 2015 / early 2016, the global economy is on a renewed upswing, with global trade and capex having regained vigor (Chart 1). Similar upswings in aged economic expansions have historically been the ideal breeding ground for global monetary tightening. However, the world economy is still dealing with two deflationary anchors: two decades of over-investment in emerging markets that have led to chronic overcapacity globally, and a strong preference for savings - a legacy of the great financial crisis (GFC) in the West and of financial repression in China. Thanks to this confluence of forces, global central banks have been fearful of tightening policy, hence, global policy rates continue to hover near multi-generational lows. Yet, now that the Federal Reserve has opened Pandora's box and raised rates four times, the question on every investor's mind is who is next. In this piece, we examine a few key domestic indicators for each G10 central bank (CB), and try to categorize CBs according to their likelihood of being the next one to tighten policy. We find three groups. The first one with the highest likelihood of hiking includes New Zealand, Sweden, and Canada. We place Australia, the U.K., and the Euro Area in the somewhat-likely-to-tighten camp. Finally, among the economies where we see little scope for tighter policy are Norway, Switzerland, and Japan. Using this ranking, we examine the implications for these countries' respective currencies and equity markets' relative performance. In this optic, it is important to remember that while conventional wisdom dictates that the stock market needs a depreciating currency in order to advance, empirically, countries with appreciating exchange rates have tended to outperform the global equity benchmark, reflecting the effect of international flows into these economies and markets.1 Finally, we look forward to publish in the coming months a quantitative model based on the indicators used in this report. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Anastasios Avgeriou, Vice President Global Alpha Sector Strategy & U.S. Equity Strategy anastasios@bcaresearch.com Most Likely To Increase Rates First: 1) New Zealand Chart 2New Zealand New Zealand New Zealand The real Official Cash Rate has never been at such a discount to trend real GDP growth (Chart 2). As a result, nominal GDP is growing at a strong 6% a year, and core inflation is moving back toward 2%. Additionally, nominal retail sales are expanding at nearly 8% per year, the highest pace since 2007. According to the OECD, GDP is now nearly 2% above trend, which highlights the inflationary nature of New Zealand's economy. Supporting that, capacity constraints are becoming rampant, despite strong immigration into the country, unemployment is now nearly 1% below equilibrium, further confirming that the Reserve Bank of New Zealand is keeping policy at too-stimulative levels. This time around, hiking rates will not be a policy mistake as it was in both 2010 and 2014. In 2010, the difference between real rates and trend real GDP growth was much narrower than today, and the output gap was still very negative. In 2014, measures of slack were also not supportive of higher rates, and a rollover in core inflation as well as muted retail sales growth created additional headwinds. Most Likely To Increase Rates First: 2) Sweden Chart 3Sweden Sweden Sweden The Riksbank's repo rate has been driven lower in response to the European Central Bank's own bias, resulting in a Swedish repo rate of -0.5%. The gap between the real policy rate in Sweden and trend GDP growth is hovering around record-low levels (Chart 3). Supported by such a stimulative policy setting, Swedish non-financial private credit has expanded massively, hitting 230% of GDP. Today, the output gap is in positive territory and the unemployment gap indicates that the labor market has tightened considerably. In fact, both measures are congruent with the levels recorded during prior rate-tightening cycles. Core inflation is still below the central bank's 2% target, but is accelerating higher. The Riksbank's resource utilization indicator is further confirming this trend and points toward much higher inflation in the second half of 2017.2 Retail sales have been soggy, but they are picking up anew, clearing the way for a rate hike. Crucially, under the tutelage of Stefan Ingves, the Riksbank has been extremely dovish, but his second term as head of the institution ends this year. For now, he does not look set to be re-appointed. His re-appointment constitutes the greatest risk to our Riksbank view. Most Likely To Increase Rates First: 3) Canada Chart 4Canada Canada Canada The gap between the real policy rate and trend real GDP growth is still very negative, much more so in fact than was the case in 2010, the last time the Bank of Canada (BoC) tried to hike interest rates. The output gap and the unemployment gap continue to point toward a small degree of slack in the Canadian economy (Chart 4). Nonetheless, the BoC expects the output gap to close in 2018. However, the amount of slack in the economy remains very low compared to what prevailed in 2010. Like in the U.S., core inflation has recently sagged, but retail sales continue to grow at a healthy pace. Canadian policy rates have rarely diverged from those in the U.S. for long as the Canadian economy is deeply integrated in the U.S. supply chain. This means that economic impulses in the U.S. are often transferred to Canada. The Fed increasing rates in the U.S. puts pressure on the BoC. If rates diverge for too long, the Loonie will weaken considerably, exacerbating inflationary pressures in Canada. Recent communications of the BoC's most senior staff indicate a very sharp move away from dovishness. Middle Of The Pack: 1) Australia Chart 5Australia Australia Australia The gap between real policy rates and trend real GDP growth is in stimulative territory, but it is not at the level seen in New Zealand, Sweden or Canada. While the unemployment gap suggests the labor market is becoming increasingly tight, the OECD's measure of the output gap still stands near record lows, suggesting that in aggregate there remains substantial slack in Australia (Chart 5). This paints a mixed picture rather than an indubitably good or bad one. Core inflation remains in a downtrend and nominal retail sales are growing at very low rates, further highlighting that monetary policy is not as accommodative as in New Zealand or Canada. Improvement in global trade continues to support the Australian economy, and strong real estate activity suggests that policy is too easy for domestic asset prices. These two forces are critical in preventing Australia from falling into the bottom basket of central banks. Even if a small deceleration in global activity emerges, so long as it does not degenerate into the kind of vicious commodity selloff experienced in the second half of 2015 and early 2016, the Australian economy will be able to avoid another deceleration. Middle Of The Pack: 2) The U.K. Chart 6U.K. U.K. U.K. On many fronts, the U.K. looks ripe for an imminent rate hike. The gap between the real policy rate and trend real GDP growth is as depressed as the levels recorded in the countries in the first bucket, suggesting that the Bank of England's policy stance is extremely accommodative (Chart 6). However, like in Australia, measures of economic slack paint a mixed picture. The unemployment gap points to an absence of slack, while the output gap remains negative and indicative of some slack in the U.K. Retail sales have been lifted by the recent surge in inflation, with core consumer prices now growing at a 2.6% annual rate. However, this picture is distorted. Real retail sales have massively decelerated, and the surge in inflation has had nothing to do with domestic conditions but has been entirely due to the pass-through associated with the near-20% collapse in the trade-weighted pound since November 2015. Beyond the negative output gap, the key reason why the BoE is not at the top of the list of potential hikers is because U.K. household inflation expectations remain well behaved, and the economy could continue to decelerate in the face of uncertainty associated with Brexit. This could even prompt Mark Carney to keep an even more dovish stance that we or the market currently anticipate. Middle Of The Pack: 3) The Euro Area Chart 7Euro Area Euro Area Euro Area The gap between the real policy rate and trend real GDP growth in the euro area is actually also at extremely stimulative levels (Chart 7), partly explaining why the European economy has been able to generate so many positive data surprises. However, the euro area economy still needs easy policy. The output gap remains very negative and unemployment is still below equilibrium. In fact, as we have argued, this latter indicator may even underestimate the amount of labor market slack in Europe, as measures of labor underutilization remain very elevated. Euro area core inflation has been moving up, but at around 1% remains well shy of the ECB's objective of close to but below 2%. True, officially the ECB targets headline inflation, but Draghi's emphasis on underlying domestic inflation trends belies a focus on core inflation. Ultimately, the combination of labor underutilization, simmering political risk in Italy and a still-negative output gap suggests the ECB in unlikely to lift interest rates until at least late 2018. The biggest risk to our view would be for the ECB to tighten policy more than we or even the market anticipate. This would put the ECB ahead of the BoE. The Laggards: 1) Norway Chart 8Norway Norway Norway The gap between Norway's real policy rate and trend real GDP growth is still indicative of an easy policy stance. However, the recent dip in core inflation has caused an inadvertent policy tightening, as illustrated by the gap's sharp narrowing (Chart 8). The OECD's measure of Norway's output gap is very negative, and the unemployment rate has not been this deeply above equilibrium in more than 20 years. As such, there seems to remain large amounts of slack in the Norwegian economy. Corroborating this assessment, Norwegian wages are contracting at a 4% annual pace. Norwegian retail sales have been very weak, and core inflation has collapsed from 4% to 1.5%. This easing in inflation is a blessing for the Norges Bank as this allows it to focus on the large amount of slack still present in the economy. The Laggards: 2) Switzerland Chart 9Switzerland Switzerland Switzerland Despite a deeply negative nominal policy rate and a continuously expanding central bank balance sheet, Switzerland monetary policy does not seem to be very easy, as the gap between the real policy rate and the trend real GDP growth rate is in neutral territory (Chart 9). The OECD's output gap and the difference between the headline unemployment rate and equilibrium unemployment rate both point toward plentiful slack in the Swiss economy. Swiss wage growth also remains quite tame, only hitting 0.1% last quarter. Core inflation remains well below target as it only modestly moved back into positive territory three months ago. The confluence of not-so-easy monetary policy and plentiful excess capacity suggests that despite the challenging conditions for Swiss pension plans and insurance companies created by deeply negative rates the Swiss economy is not yet ready to handle tighter monetary policy. The Laggards: 3) Japan Chart 10Japan Japan Japan Japan might be the most perplexing economy in the G10 right now, and the Bank of Japan is in the toughest position of all the major central banks in the advanced economies. Like Switzerland, despite negative nominal short-term interest rates and large asset purchases by the BoJ, the gap between Japan's real policy rates and trend real GDP growth suggests that policy is only at a neutral setting (Chart 10). This would seem appropriate given that both the output gap and the unemployment gap point to little spare capacity in Japan. However, this does not square with core inflation moving back into negative territory and barely expanding retail sales. Ultimately, Japan's problem is two-fold. First, the unemployment gap underestimates the amount of labor underutilization in Japan, as output per hour worked remains 11% and 34% behind that of the OECD and the U.S, respectively. Second, extremely depressed Japanese inflation expectations continue to result in an extraordinarily flat Philips curve. Due to these dynamics, we expect that it will take continued sustained efforts by the BoJ to overheat the economy before any signs of inflation emerge. FX Implications Based on our assessments, we would expect the RBNZ, the Riksbank and the BoC to be the first central banks to hike now that the Fed has blazed the trail. Within this group, the RBNZ is potentially the cleanest story, as all factors are aligned. We would expect the RBNZ to hike late summer / early fall 2017. Technically, the Riksbank seems in a better place to hike rates than the BoC. However, the leadership of the BoC is already preparing the market for higher rates. Canadian rates could also rise as soon as late summer / early fall 2017. Meanwhile, so long as Ingves remains head of the Riksbank, the Swedish central bank will likely stand pat. Thus, we would expect the first hike to materialize early next year, as soon as a new governor takes the helm, although, we believe markets will begin pricing in such a hike as soon as his replacement is announced. In the second group of central banks, we expect the RBA to be the first to increase rates. The BoE does face a much more inflationary environment than the RBA, but the U.K.'s economic uncertainty remains such that the BoE is likely to tread carefully and wait to see how the economy handles the new wave of political trauma unleashed by this month's election. The ECB is likely to begin tapering its own purchases at the end of 2017, but our base case anticipates that it will not touch policy rates until well into 2018. Among the laggards, the Norges Bank will most likely be the first to push up rates - something we do not anticipate until late 2018. While BCA expects oil prices to rebound, this is unlikely to boost the economy fast enough to close the output gap for at least 18 months. Switzerland and Japan need to do a lot of work before their respective economies generate any kind of inflationary pressures. We do not anticipate any tightening for Switzerland until well after the ECB has moved. The BoJ may not tighten policy for the remainder of this decade. This means that the CAD and the NZD are likely to prove to be the best-performing currencies in the dollar bloc. Investors should stay short AUD/NZD and AUD/CAD. CAD/NOK also possesses more upside. The SEK could prove to be the best performing European currency. Swedish money markets are pricing in only 40 basis points of hikes over the next 12 months, something that seems too low considering the inflationary risk in that country. Stay short EUR/SEK. The EUR/USD rebounded this week on the back of seemingly hawkish comments by Draghi. Even when the ECB somewhat backtracked and communicated that the market had misinterpreted the speech, EUR/USD looked the other way. This confirms our fear that the momentum in this pair is too strong to fight. EUR/USD should retest 1.15-1.16, the upper bound of its trading range put in place since March 2015. Based on our economics work, any move above 1.15 should be used to short the euro. The pound will continue to suffer from a political discount, however, because our base case expects the BoE to tighten policy before the ECB, we continue to recommend that investors use moves above 0.88 to begin shorting EUR/GBP. The SNB is unlikely to remove its cap on the Swiss franc, which means the natural upward pull created by the large net international position of Switzerland will be of little solace for investors. Finally, the JPY should be the worst performing currency in the G10 as the BoJ will not be able to lift rates - a great handicap when, as BCA expects, global bond yields are likely to enjoy more upside than downside over the next 12 months. Equity Implications U.S. Equities Chart 11U.S. U.S. U.S. Contrary to popular belief equities and the currency are joined at the hip especially during currency bull markets. A rising currency tends to attract flows and equities outperform in common and local currency terms. Keep in mind that domestic equity exposure dominates stock market weightings, further solidifying the positive currency and equity correlation. The top panel of Chart 11 shows that this relationship is extremely tight in the U.S. with equities outperforming the MSCI ACWI when the dollar advances and suffering a setback when the greenback depreciates. The Fed has raised rates three times since December 2015 and is slated to tighten monetary policy one more time later this year. This is well telegraphed to the markets, and thus the U.S. dollar has been in sell off mode for the past 6 months, weighing on relative equity performance. The relative economic surprise indexes also have an excellent track record in forecasting relative equity momentum, and the current message is grim for relative share prices. We expect the U.S. to continue to trail other G10 bourses in the coming months and the MSCI ACWI as other CBs have more scope to tighten monetary policy, and recommend an underweight stance in global equity portfolios. Bank/financials performance is also closely linked to monetary policy. While the yield curve flattening tends to suppress net interest margins (NIM), the recovery in loan volumes and drop in NPLs owing to a pickup in economic growth more than offsets the fall in NIMs. We continue to recommend overweight exposure in U.S. banks/financials both in global and U.S. only portfolios.3 New Zealand Equities Chart 12New Zealand New Zealand New Zealand The positive stock and currency correlation exists in New Zealand. Currently, the Kiwi has been rising, but relative equities have not followed suit. If our analysis proves prescient and the RBNZ becomes the next G10 CB to hike, then a playable relative equity catch up phase will materialize (Chart 12). The relative surprise index is firing on all cylinders and corroborates the bullish economic message from our macro analysis and hints that New Zealand equities are a buy. We recommend an overweight stance in New Zealand stocks in global equity portfolios. While all the rest of the G10 have a domestic banking sector, New Zealand is the exception. Australian banks dominate the banking scene in New Zealand, and thus serve as a good proxy. We are comfortable to have a modest Australian banks/financials exposure in New Zealand only portfolios. However, there is one caveat: the housing market is bubbly. While excesses are well documented, we doubt that the housing markets would burst either in Australia or in New Zealand in the coming 6-12 months and bring down the Australian banking sector. In such a time frame, both CBs will still be early in their respective tightening cycles. Swedish Equities Chart 13Sweden Sweden Sweden The Swedish krona moves in lockstep with relative share prices, a relationship that has been in place for the better part of the past two decades (Chart 13). Were the Riksbank to raise the policy rate from deeply negative territory, as our macroeconomic analysis pegs it as second most likely, then equities will outperform the MSCI ACWI, and we recommend an above benchmark allocation in global equity portfolios. Economic surprises in Sweden continue to outnumber the G10, heralding additional momentum gains in relative share prices (bottom panel). The elimination of NIRP would also benefit the banking sector. NIRP serves as a noose around banks' necks, as bankers cannot pass on NIRP to retail depositors weighing on NIMs. Chart 21 in the Appendix shows that Swedish financials comprise over 30% of the overall Swedish market and drive overall market performance. Thus, we are comfortable with an overweight stance in financials in Swedish only equity portfolios given the prospects of tighter monetary policy in the coming quarters. Canadian Equities Chart 14Canada Canada Canada The Loonie and relative equity performance also move in tandem (Chart 14). At the current juncture the bear market in oil prices has dampened both the currency and equities, as Canada is an excellent proxy for commodity prices in general and oil prices in particular. The BoC is the third most likely CB to raise interest rates in the coming months according to our analysis, raising the odds of a reversal of fortunes for Canadian equities. The relative economic surprise index is surging, opening a wide gap with relative share price momentum. If our thesis proves accurate and the BoC pulls the trigger soon, then Canadian equities will gain some traction. Under such a backdrop we recommend an overweight stance in global equity portfolios. In terms of financials, Canadian financials' market capitalization weight is the second largest in the G10, exerting significant influence in overall equity direction. If the commodity complex is healthy enough for the BoC to tighten monetary policy, then banks will outperform on the back of firming loan growth and receding commodity related NPLs. Nevertheless, the housing market poses a clear risk. Were a housing crisis to grip the Canadian economy, bank earnings and thus performance would suffer a sizable blow. Our sense is that such an outcome is highly unlikely in the next year, making us comfortable recommending overweight financials exposure in Canadian only equity portfolios. Australian Equities Chart 15Australia Australia Australia The positive correlation between FX rates and relative equity performance is prevalent in Australia (Chart 15). Currently, the Aussie has stayed resilient, but equities have given way suffering alongside commodities in general and iron ore prices in particular. The RBA sits in the middle of the pack in terms of hiking interest rates next according to our thesis, but still remains the fourth most likely CB in the G10 to pull the trigger ahead of the BoE and the ECB. As such, we recommend a neutral weight in global equity portfolios. While the relative economic surprise index has vaulted higher, the positive correlation with relative share price momentum seems to have broken down in recent years. Similar to Canada, Australian financials comprise a large chunk of the broad equity market (see Chart 21 in the Appendix on page 24), setting the tone for overall equity returns. If Canada's housing market is frothy, then Australia is a definite bubble and poses a significant risk to the banking sector. The APRA is breathing down banks' necks and that is reflected in recent bank underperformance. As we mentioned earlier, we doubt the Australian housing market blows up in the next 6-12 months as the RBA will be in the early innings of a tightening cycle. As a result, only a benchmark allocation is warranted in Australian banks in Australian only portfolios. U.K. Equities Chart 16U.K. U.K. U.K. Cable and relative U.K. equity performance also follow our currency/FX positive correlation playbook (Chart 16). Relative share prices have ticked up recently taking cue from the rebound in sterling. British economic surprises have been outnumbering the G10 post Brexit, and sport a positive correlation with relative share price momentum. Our U.K. macroeconomic analysis highlights that the BoE stands right in the middle of the CB pack. Importantly, the BoE is our "surprise risk" of staying easy for longer than the economic variables would suggest as the dust clears from the Brexit aftermath. Under such a backdrop we recommend a modest underweight in U.K. equities in global equity portfolios. Similarly, U.K. banks also warrant a slight underweight stance in U.K. only equity portfolios. Eurozone Equities Chart 17Euro Area Euro Area Euro Area Euro area stocks and the euro have been positively correlated especially since 2003. Year-to-date EUR/USD is up roughly 10% and Eurozone equities have been stellar outperformers. The catalyst for the euro's sizable gains has been the market's realization that the ECB passed its maximum easing in Q1/2017. Receding geopolitical uncertainty has also played a key role. In addition, the economy has responded well both to the extraordinarily easy monetary policy measures and move away from austerity. The bottom panel of the Chart 17 shows that relative economic surprises are probing 5-year highs pulling relative equity momentum higher. While our macro analysis suggests that the ECB stays pat for a while longer, our "surprise risk" is that the ECB moves earlier than we expect and removes some of the extreme monetary accommodation. As a result we continue to recommend above benchmark exposure both in Eurozone equities and banks/financials. Importantly, not only will euro area banks benefit from the eventual ECB's removal of NIRP and the related boost to NIMs, but also NPLs have peaked and will continue to drift lower along with the unemployment rate. More recently, the speedy and contained resolution of two Italian bank failures along with the absorption of two Spanish banks by Santander and Bankia are a giant step in the right direction. These moves also suggest that there is political will to overcome the banking issues in the euro area. Additional bank cleanup is likely and this is a welcome development in the Eurozone that should entice healthier banks to extend credit to the economy. Norwegian Equities Chart 18Norway Norway Norway Over the past two decades, the Norwegian krone and relative equity performance have moved in lockstep (Chart 18). Year-to-date, relative Norwegian equities have fallen to fresh cycle lows. Similar to Canada, the country's substantial oil dependency has weighed on relative share prices and also knocked down the krone. Our macro analysis concluded that the Norges Bank will be late in lifting interest rate and sits at the bottom of the G10 CBs. As a result, we recommend underweight exposure in Norwegian stocks in global equity portfolios. Financials in Norway comprise one fifth of the stock market's capitalization (Chart 21 in the Appendix on page 24) and have been on a nearly uninterrupted run since the end of the GFC and catapulted to multi-decade highs. Given our thesis of the Norges Bank staying late in raising rates we recommend lightening up on financials equities in Norwegian only equity portfolios. Swiss Equities Chart 19Switzerland Switzerland Switzerland Since the late 1990s relative Swiss share prices and the CHF have been enjoying an almost perfect positive correlation (Chart 19). At the current juncture Swiss stocks have been propelling higher versus the MSCI ACWI as the franc has been appreciating. There are extremely low odds that the SNB would move the needle in terms of normalizing interest rates any time soon, according to our analysis. Keep in mind that the SNB is conducting the ultimate QE experiment by purchasing U.S. stocks, underscoring that there are a lot of layers/levers of momentary policy easing that it will have to eventually to unwind. The implication is that we would lean against recent strength in the Swiss equity market and recommend a below benchmark allocation. Switzerland financials have the third lowest market cap weight in the G10 as UBS and CS are still licking their wounds from the aftermath of the GFC. Relative financials performance has been soft and taken a turn for the worse recently in marked contrast with global financials exuberance since Brexit. Our macro analysis suggests that a below benchmark allocation is warranted in financials in Swiss only portfolios. Japanese Equities Chart 20Japan Japan Japan The Japanese yen and relative equity performance were joined at the hip from the mid-1990s until 2009. From the end of the GFC until 2015 this correlation broke down as Japan has been in-and-out of recession. Since then however, there is tentative evidence that Japanese equities and the yen have resumed moving in tandem (Chart 20). Our macroeconomic analysis suggests that Japan will be the last G10 CB to lift interest rates. While our study would signal that investors should avoid Japanese equities, we do not have high confidence in that view. The break and resumption in the equity/currency correlation is worrisome and suggests that other more important factors are in play dictating relative share price performance. As a result, we would modestly overweight Japanese equities in global equity portfolios in line with BCA’s Global Investment Strategy service view.4 On the financials front, relative performance in Japan has fallen into oblivion. NIRP is anchoring NIMs. But, an extremely low unemployment rate suggests that NPLs will continue to probe multi decade lows and provide an offset to bank EPS. Thus, we would stick with a neutral weighting in Japanese financials.5 Appendix Chart 21G10 Financial Market Cap Weights Who Hikes Next? Who Hikes Next? 1 For a more detailed discussion on the correlation between equity prices and the currency market, please see Global Alpha Sector Strategy Special Report titled, "Can The S&P 500 Rise Alongside The U.S. Dollar?", dated October 7, 206, available at gss.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report titled, "Central Banks Are Sticking To Their Guns", dated June 16, 017, available at fes.bcaresearch.com 3 Please see U.S. Equity Strategy Weekly Report titled, "Girding For A Breakout?", dated May 1, 2017, available at uses.bcaresearch.com 4 Please see Global Investment Strategy - Strategy Outlook "Third Quarter 2017: Aging Bull", June 30, 2017, available at gis.bcaresearch.com 5 Please see Global Alpha Sector Strategy Weekly Report titled "The Year Of The Letter "R"", January 13, 2017, available at gss.bcaresearch.com

Highlights The divergence between global bond yields and equity prices is not as puzzling as it may first appear. Thus far, lower inflation has dampened the need for central banks to tighten monetary policy. This has caused bond yields to fall, lifting stocks in the process. Looking out, the combination of faster growth and dwindling spare capacity will cause inflation to rise. This is particularly the case for the U.S., where the economy has already reached full employment. The "blow-off" phase for the U.S. economy is likely to last until mid-2018. The dollar and Treasury yields will move higher over this period. The euro and the yen will suffer the most against a resurgent greenback, the pound less so. China's economy will remain resilient, helping to boost commodity prices. This will support the Canadian and Aussie dollars. Stronger global growth will provide a tailwind to emerging markets. However, at this point, most of the good news is already reflected in EM asset valuations. Feature Stocks And Bonds: A Curious Divergence Chart 1Global Growth: Increasing Optimism Global Growth: Increasing Optimism Global Growth: Increasing Optimism One could be forgiven for thinking that equity and bond investors are living on different planets. Global bond yields have been trending lower thus far this year, while stocks have been setting new highs. Are bonds signaling an imminent slowdown which equity investors are willfully ignoring? Not necessarily. Almost all of the decline in bond yields has been due to falling inflation expectations. Real yields have remained reasonably steady, suggesting that growth worries are not foremost on investors' minds. The fact that consensus global growth estimates for 2017 and 2018 have continued to grind higher is consistent with this observation (Chart 1). A quiescent inflation picture has given investors more confidence that the Fed will not need to raise rates aggressively. This has pushed down bond yields, weakened the dollar, and fueled the rally in stock prices. The decline in headline inflation, in turn, has been largely driven by lower commodity prices. In the U.S., several one-off factors - including Verizon's decision to move to unlimited data plans, a temporary lull in health care inflation, and a drop in airline fares - have helped keep core inflation in check. The U.S. Economy: It Gets Better Before It Gets Worse Looking out, global growth is likely to remain firm. This should ultimately translate into higher inflation, particularly in the U.S., where the economy has already achieved full employment. Granted, as we discussed last week,1 the U.S. business cycle expansion is getting long in the tooth. However, history suggests that the transition between boom and bust is often accompanied by a revelry of sorts where things get better before they get worse. Call it a "blow-off" phase for the business cycle. The example of the late 1990s - the last time the U.S. unemployment rate fell below NAIRU for an extended period of time - comes to mind. Chart 2 shows that final domestic demand accelerated to 8.3% in nominal terms in Q1 of 2000. Personal consumption growth surged, reaching 8.4% in nominal terms and 5.7% in real terms. Obviously, there are many differences between now and then. However, there is at least one critical similarity: The unemployment rate stood at 4.3% in January 1999. This is exactly where it stands today. And if it keeps falling at its current pace, the unemployment rate will dip below its 2000 low of 3.8% by next summer. As was the case in the past, an overheated labor market will lead to faster wage growth. In the U.S., underlying wage growth has accelerated from 1.2% in 2010 to 2.4% at present (Chart 3). Chart 2The Late 1990s: An End-Of-Cycle Blow-Off The Late 1990s: An End-Of-Cycle Blow-Off The Late 1990s: An End-Of-Cycle Blow-Off Chart 3Stronger Labor Market Is Leading To Faster Wage Growth Stronger Labor Market Is Leading To Faster Wage Growth Stronger Labor Market Is Leading To Faster Wage Growth Granted, this is still well below the levels seen in 2000 and 2007. However, productivity growth has crumbled over the past decade while long-term inflation expectations have dipped. Real unit labor costs - a measure of compensation which adjusts for shifts in productivity growth and inflation - are rising at a faster rate than in 2007 and close to the pace recorded in 2000 (Chart 4). In fact, real wage growth in the U.S. has eclipsed business productivity growth for three straight years (Chart 5). As a result, labor's share of national income is now increasing. Chart 4Real Unit Labor Cost Growth: Back To Its 2000 Peak Real Unit Labor Cost Growth: Back To Its 2000 Peak Real Unit Labor Cost Growth: Back To Its 2000 Peak Chart 5Real Wages Now Increasing Faster Than Productivity Real Wages Now Increasing Faster Than Productivity Real Wages Now Increasing Faster Than Productivity What happens to aggregate demand when the share of income going to workers rises? The answer is that at least initially, demand goes up. Companies typically spend less of every marginal dollar of income than workers. This is especially the case in today's environment where the distribution of corporate profits has become increasingly tilted towards a few winner-take-all firms which, for the most part, are already flush with cash (Chart 6). Thus, a shift of income towards workers tends to boost overall spending. In addition, an overheated labor market typically generates the biggest gains for workers at the bottom of the income distribution. Wages for U.S. workers without a college degree have been rising more quickly than those with a university education for the past few years (Chart 7). Such workers often live paycheck-to-paycheck and, hence, have a high marginal propensity to consume. Chart 6A Winner-Take-All Economy A Winner-Take-All Economy A Winner-Take-All Economy Chart 7Tighter Labor Market Boosting Wages Of Less Educated Workers Tighter Labor Market Boosting Wages Of Less Educated Workers Tighter Labor Market Boosting Wages Of Less Educated Workers Let's Get This Party Started The discussion above suggests that U.S. aggregate demand could accelerate over the next few quarters. There is some evidence that this is already happening (Chart 8). Despite a moderation in auto purchases, real PCE growth is still tracking at 3.2% in the second quarter according to the Atlanta Fed's GDPNow model. And with the personal saving rate still stuck at an elevated 5.3%, there is scope for consumer spending to grow at a faster rate than disposable income. Chart 9 shows that the current saving rate is well above the level one would expect based on the ratio of household net worth-to-disposable income. Chart 8Solid Near-Term Outlook For U.S. Consumers Solid Near-Term Outlook For U.S. Consumers Solid Near-Term Outlook For U.S. Consumers Chart 9 Financial conditions have eased over the past six months thanks to lower Treasury yields, narrower credit spreads, a weaker dollar, and higher equity prices (Chart 10). Historically, an easing in financial conditions has foreshadowed faster growth (Chart 11). This could make the coming blow-off phase even more explosive than in past business cycles. Some commentators have noted that while financial conditions have eased, bank lending has slowed significantly. If true, this would imply that easier financial conditions are not boosting credit growth in the way one might expect. The problem with this argument is that it takes a far too limited view of the U.S. financial system. Although bank lending to companies has indeed slowed, bond issuance has soared. In fact, total nonfinancial corporate debt rose by $212 billion in the first quarter according to the Fed's Financial Accounts database, the largest increase in history (Chart 12). Chart 10Financial Conditions Have Been Easing... Financial Conditions Have Been Easing... Financial Conditions Have Been Easing... Chart 11...Which Will Support Growth ...Which Will Support Growth ...Which Will Support Growth Chart 12Nonfinancial Corporate Debt Surged In Q1 Nonfinancial Corporate Debt Surged In Q1 Nonfinancial Corporate Debt Surged In Q1 All Good Things Must Come To An End Unfortunately, the burst of demand that often occurs in the late stages of business cycle expansions contains the seeds of its own demise. Initially, when consumer spending accelerates, firms tend to react by expanding capacity. This translates into higher investment spending. However, as labor's share of income keeps rising, an increasing number of firms start incurring outright losses. This causes them to dismiss workers and cut back on investment spending. Such a souring in corporate animal spirits is not an immediate risk for the U.S. economy. Hiring intentions remain solid and businesses are still signaling that they expect to increase capital spending over the coming months (Chart 13). Profit margins are also quite high by historic standards, which gives firms greater room for maneuver. This will change over time, however. Margins are already falling in the national accounts data (Chart 14). History suggests that S&P 500 margins will follow suit. This raises the risk that capex and hiring will start to slow late next year, potentially sowing the seeds for a recession in 2019. We remain overweight global equities on a cyclical 12-month horizon, but will be looking to significantly pare back exposure next summer. Chart 13Corporate America Feeling Great Again Corporate America Feeling Great Again Corporate America Feeling Great Again Chart 14Economy-Wide Margins Have Slipped Economy-Wide Margins Have Slipped Economy-Wide Margins Have Slipped The Dollar Bull Market Is Not Over Yet Chart 15Historically, A Rising Labor Share Has Pushed Up The Dollar Historically, A Rising Labor Share Has Pushed Up The Dollar Historically, A Rising Labor Share Has Pushed Up The Dollar Until U.S. growth does decelerate, the path of least resistance for bond yields and the dollar will be to the upside. Chart 15 shows the strikingly close correlation between labor's share of income and the value of the trade-weighted dollar. As noted above, the initial effect of accelerating wage growth is to put more money into workers' pockets. This results in higher aggregate demand and, against a backdrop of low spare capacity, rising inflation. Historically, such an outcome has prompted the Fed to expedite the pace of rate hikes, leading to a stronger dollar. This time is unlikely to be any different. The market is currently pricing in only 21 basis points in Fed rate hikes over the next 12 months. This seems far too low to us. Other things equal, a stronger dollar implies a weaker euro and yen. Improved export competitiveness will lead to better growth prospects and higher inflation expectations in the euro area and Japan. Unless the ECB and the BoJ respond by tightening monetary policy, short-term real rates will fall. This, in turn, could put further downward pressure on the euro and the yen. The ECB And The BoJ Will Not Follow The Fed's Lead Many commentators have argued that better growth prospects will cause the ECB and the BoJ to follow in the Fed's footsteps and take away the punch bowl. We doubt it. Labor market slack is still considerably higher in the euro area than was the case in 2008. Outside of Germany, the level of unemployment and underemployment in the euro area is about seven points higher than it was before the Great Recession (Chart 16). If anything, the market has priced in too much tightening from the ECB. Our months-to-hike measure has plummeted from a high of 65 months in July 2016 to 28 months at present (Chart 17). Investors now expect real rates in the U.S. to be only 23 basis points higher than in the euro area in five years' time. This is well below the 76 basis-point gap in the equilibrium rate between the two regions that Holston, Laubach, and Williams estimate (Chart 18). Chart 16Euro Area: Labor Market Slack Is Still High Outside Of Germany Euro Area: Labor Market Slack Is Still High Outside Of Germany Euro Area: Labor Market Slack Is Still High Outside Of Germany Chart 17ECB: Markets Are Pricing In Too Much Tightening ECB: Markets Are Pricing In Too Much Tightening ECB: Markets Are Pricing In Too Much Tightening Chart 18The Neutral Rate Is Lowest In The Euro Area The Neutral Rate Is Lowest In The Euro Area The Neutral Rate Is Lowest In The Euro Area As for Japan, while it is true that the unemployment rate has fallen to 2.8% - a 22-year low - this understates the true amount of slack in the economy. Output-per-hour in Japan remains 35% below U.S. levels. A key reason for this is that many Japanese companies continue to pad their payrolls with excess labor. This is particularly true in the service sector, which remains largely insulated from foreign competition. In any case, with both actual inflation and inflation expectations in Japan nowhere close to the BoJ's target, this is hardly the time to be worried about an overheated economy. And even if the Japanese authorities were inclined to slow growth, it would be fiscal policy rather than monetary policy that they would tighten first. After all, they have been keen to raise the sales tax for several years now. The Pound Will Rebound Against The Euro, But Weaken Further Against The Dollar Chart 19Pound: Unloved And Underappreciated Pound: Unloved And Underappreciated Pound: Unloved And Underappreciated While we continue to maintain a strong conviction view that the euro and yen will weaken against the dollar, we are more circumspect about other currencies. Bank of England Governor Mark Carney played down speculation this week that the BoE would raise rates later this year, noting in his annual speech at London's Mansion House that "now is not yet the time to begin that adjustment." U.K. growth has been the weakest in the G7 so far in 2017, partly because of growing angst over the forthcoming Brexit negotiations. Nevertheless, U.K. inflation remains elevated and fiscal policy is likely to be eased in the November budget, as Chancellor Hammond confirmed in a BBC interview on Sunday. Sterling is already quite cheap based on our metrics (Chart 19). Our best bet is that the pound will weaken against the dollar over the next 12 months but strengthen against the euro and the yen. We are currently long GBP/JPY. The trade has gained 7.2% since we initiated it in August 2016. CAD Has Upside We went long CAD/EUR in May. Despite the downdraft in oil prices, the trade has managed to gain 2.6% thus far. We are optimistic on the Canadian dollar over the coming months. Our energy strategists remain convinced that crude prices are heading higher. They expect global production to increase by only 0.7 MMB/d in 2017, compared to 1.5 MMB/d growth in consumption. Consequently, oil inventories should fall over the remainder of this year. If history is any guide, this will lead to a rebound in oil prices (Chart 20). The Bank of Canada has also turned more hawkish. Senior Deputy Governor Carolyn Wilkins suggested last week that interest rates are likely to rise later this year. The market is now pricing in a 84% chance of a rate hike in 2017, up from only 18% earlier this month. The Canadian economy continues to perform well (Chart 21). Retail sales are growing briskly, the unemployment rate is close to its lowest level in 40 years, and goods exports are recovering thanks to a weak loonie and stronger growth south of the border. While the bubbly housing market remains a source of concern, this is as much a reason to raise interest rates - to prevent further overheating - as to cut them. Chart 20Falling Oil Inventories Should Lead To Higher Crude Prices Falling Oil Inventories Should Lead To Higher Crude Prices Falling Oil Inventories Should Lead To Higher Crude Prices Chart 21Canadian Economy: Chugging Along Canadian Economy: Chugging Along Canadian Economy: Chugging Along China Will Drive The Aussie Dollar And EM Assets After a very strong start to the year, Chinese growth has slipped a notch. Housing starts slowed in May, as did gains in property prices. M2 growth decelerated to 9.6% from a year earlier, the first time broad money growth has fallen into the single-digit range since the government began publishing such statistics in 1986. Still, the economy is far from falling off a cliff, as evidenced by the fact that the IMF upgraded its full-year 2017 GDP growth forecast from 6.6% to 6.7% last week. Real-time measures of industrial activity such as railway freight traffic, excavator sales, and electricity production remain upbeat. Export growth is accelerating thanks to a weaker currency and stronger global growth. The PBoC's trade-weighted RMB basket has fallen by over 8% since it was introduced in December 2015. Retail sales continue to expand at a healthy clip. The percentage of households that intend to buy a new home has also surged to record-high levels. This should limit the fallout from the government's efforts to cool the housing market. The rebound in exports and industrial output is helping to lift producer prices. Higher selling prices, in turn, are fueling a rebound in industrial company profits (Chart 22). A better profit picture should support business capital spending in the coming months. The government also remains cognizant of the risks of tightening policy too aggressively, especially with the National Party Congress slated for this autumn. The PBoC injected 250 billion yuan into the financial system last Friday. This was the single biggest one-day intervention since January, when demand for cash was running high in the lead up to the Chinese New Year celebrations. Fiscal policy has also been eased (Chart 23). So far, the "regulatory windstorm" of measures designed to clamp down on financial speculation has largely bypassed the real economy. Medium and long-term lending to nonfinancial corporations - a key driver of private-sector capital spending - has actually accelerated over the past eight months (Chart 24). Chart 22China: Higher Selling Prices Fuelling A Rebound In Profits China: Higher Selling Prices Fuelling A Rebound In Profits China: Higher Selling Prices Fuelling A Rebound In Profits Chart 23Fiscal Spending Is On The Mend Fiscal Spending Is On The Mend Fiscal Spending Is On The Mend Chart 24China: Credit To The Real Economy Is Accelerating China: Credit To The Real Economy Is Accelerating China: Credit To The Real Economy Is Accelerating The key takeaway for investors is that Chinese growth is likely to slow over the next few quarters, but not by much. Considering that fund managers surveyed by BofA Merrill Lynch in June cited fears of a hard landing in China as the biggest tail risk facing financial markets for the second month in a row, the bar for positive surprises out of China is comfortably low. If China can clear this bar, as we expect it will, it will be good news for the Aussie dollar and other commodity plays. Strong Chinese growth should provide a tailwind for EM assets. However, EM stocks and currencies have already had a major run, which limits further upside. The fact that serial-defaulter Argentina could issue a 100-year bond this week in an offering that was three times oversubscribed is a testament to that. The fundamental problems plaguing many emerging markets - high debt levels, poor governance, and lackluster productivity growth - remain largely unaddressed. Until they are, the long-term outlook for EM assets will continue to be challenging. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "The Timing Of The Next Recession," dated June 16, 2017, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades