Europe

Highlights The euro doesn't have the key attributes of a funding or a risk-off currency. This means its behavior is not fixed. While in the past it has behaved as a risk-off currency, this year it has traded as a risk-on one, correlating with key risky assets. The current episode of market volatility will not help the euro. CAD/SEK will benefit if asset-market volatility continues. A global growth deceleration helps the CAD outperform the SEK, especially as this cross trades at a discount to rate differentials. Feature As markets have begun selling off, the euro has once again become well bid. Does this reaction makes sense, or is it a move that should be faded? We are inclined to look the other way, as it is highly unlikely that the euro will benefit from market weakness this time around. The Chameleon Currency Is the euro a risk-off or risk-on currency? We believe it is neither, and that its behavior evolves over time. The reason for this is that the euro is not underpinned by one of the key attributes that offer currencies like the Swiss franc or the yen their strong defensive characteristic: a large positive net international position (NIIP). While Switzerland or Japan have NIIPs in excess of 130% of GDP and 62% of GDP, respectively, the euro area owes the equivalent of 3% of GDP more to the rest of the world than the rest of world owes the Eurozone. This means the euro does not benefit from its investors repatriating funds at home when market turbulences emerge. In other words, unlike Japan or Switzerland, local investors' home bias does not come to the euro's rescue when markets vacillate. Moreover, unlike the USD, the euro is not the key reserve currency global investors seek when turmoil grips the market. The euro represents 20% of allocated global reserves, while the USD still garners 64% of these reserves. Rightly or wrongly, investors do not yet feel that the euro area has the permanence of the U.S., nor that it possesses the military might and the same capacity to control global sea lanes that the U.S. currently enjoys. Lacking these attributes, the euro is a bit of a chameleon. When investors are negative on the outlook for the European economy, the euro is used as a funding currency for carry trades. However, sometimes it is used as the vehicle to bet on a weaker dollar or an improving global economy. These two last bets are often one and the same, as the greenback remains a countercyclical currency, enjoying strength when the global economy weakens (Chart I-1). This is because the U.S. is low-beta economy as it is much less exposed to the vagaries of EM growth - a key source of variation in the global economy and the global industrial cycle - than the euro area is (Chart I-2). This is the case as the manufacturing sector is a much lower contributor to U.S. growth than to the euro area. Chart 1The Dollar Is Countercyclical The Dollar Is Countercyclical The Dollar Is Countercyclical Chart I-2The U.S. Is A Low-Beta Economy Euro: Risk On Or Risk Off? Euro: Risk On Or Risk Off? This time around, the euro seems to have been used to bet on stronger global growth and a weaker dollar. This makes sense. There is no doubt that the European economic upswing is based on domestic dynamics, but foreign factors have supercharged the European recovery this year. As Chart I-3 illustrates, French exports to Germany and China have tracked the Chinese Keqiang index - a key measure of Chinese industrial activity. More interestingly, French exports to Germany and China have been correlated with Chinese monetary conditions, suggesting China's economic rebound has filtered through a wide swath of the euro area. The action of the euro only agrees with the macroeconomic observations made above. The euro and copper - a key beneficiary of Chinese reflation - have both been moving together through most of 2017 (Chart I-4). The same holds true for EM stocks. As Chart I-5 shows, the euro has tracked the performance of EM equities relative to U.S. ones since August 2015. Both these observations make sense. A stronger China should benefit EM economies more than it benefits the U.S. A stronger China should help copper as it consumes three times as much of the red metal as the U.S., the euro area, and Japan combined. And stronger EM help Europe more than they help the U.S. Chart I-3The Positive Influence Of China The Positive Influence Of China The Positive Influence Of China Chart I-4EUR/USD Moves With Copper EUR/USD Moves With Copper EUR/USD Moves With Copper Chart I-5EUR/USD And EM Relative Performance EUR/USD And EM Relative Performance EUR/USD And EM Relative Performance Yet, as we highlighted last week, cracks are emerging in the global economy that should prove particularly painful for EM economies and EM assets.1 Behind some of these weaknesses lies China itself. After having eased fiscal and monetary conditions through most of 2015 and all of 2016, Chinese authorities are using elevated core CPI and producer price readings to reverse course. Aggregate fiscal spending is slowing massively - pointing to a negative fiscal impulse - and broad money supply is growing at its slowest pace ever (Chart I-6). The tightening in monetary conditions is bearing fruit. Chinese industrial production and retail sales disappointed this month, and the Chinese surprise index has now dipped into negative territory (Chart I-7). The boost to global growth, and EM growth especially, that was caused by Chinese imports lifted by domestic investment is now receding. Chart I-6China: Aggregate Fiscal Spending Growth##br## Is Also Weak China: Broad Money Growth Is At ##br##Record Low Chinese Policy Tightening China: Aggregate Fiscal Spending Growth Is Also Weak China: Broad Money Growth Is At Record Low Chinese Policy Tightening China: Aggregate Fiscal Spending Growth Is Also Weak China: Broad Money Growth Is At Record Low Chinese Policy Tightening Chart I-7Chinese Surprises Have ##br## Turned Negative Chinese Surprises Have Turned Negative Chinese Surprises Have Turned Negative EM assets are not ready for this, as they are priced for perfection. EM assets, which have traded in line with U.S. high-yield bond prices since 2008, are now very expensive relative to this already expensive asset (Chart I-8). A slowdown in Chinese and EM growth is likely to represent a substantially negative shock for EM equities, especially as the slowdown in EM M1 to 9.3% already portends a contraction in EM profit growth. The breakdown in U.S. and EM high-yield bond prices could easily catalyze these risks. Copper, too, is vulnerable. With an almost insatiable love for the red metal, investors are not positioned for a reversal of its bull market (Chart I-9). However, China already has near record-high inventories of copper; slowing public spending and money growth suggest that the construction industry is likely to decelerate, limiting China's intake over the next few quarters. A negative surprise is likely to come. Chart I-8EM Stocks Offer No Protection##br## Against A Slowdown EM Stocks Offer No Protection Against A Slowdown EM Stocks Offer No Protection Against A Slowdown Chart I-9Too Much Love For Copper Equals ##br##High Risk Of Disappointment Too Much Love For Copper Equals High Risk Of Disappointmentk Too Much Love For Copper Equals High Risk Of Disappointmentk Falling copper prices and underperforming EM equity prices will thus drive the euro lower, as they will be key symptoms of the waning of a crucial euro support. Moreover, the euro is now overbought, and as we have highlighted before, over-owned (Chart I-10). This picture alone should support the notion that the euro is unlikely to benefit from a short squeeze as global risk aversion rises. How could it? After all, investors did not sell the euro to fund carry trades when global growth was rising and global volatility was falling. They were buying it along with carry trades. Maybe the euro was buoyed by strong GDP prints out of Europe this week, with Germany growing at a 3.2% pace on an annualized basis in the third quarter, faster than the U.S. If this response of the euro were to be durable, it should be associated with a commensurate move in interest rate differentials. Neither the gap in 5-year risk-free rates or 1-year forward, 1-year risk free rates between Europe and the U.S. have moved in favor of the euro in the wake of the release (Chart I-11). However, in the face of the existing gap between the euro and interest rate differentials, to stay stable, the euro will need an increase in the pace of positive surprises relative to the U.S. over the coming months - something that is unlikely to materialize as European financial conditions have greatly tightened relative to the U.S. Chart I-10The Euro Has Not Been Used##br## To Fund Carry Trades The Euro Has Not Been Bsed To Fund Carry Trades The Euro Has Not Been Bsed To Fund Carry Trades Chart I-11If Growth Was The Current Driver, The Euro And ##br##Rate Differentials Would Be Moving Together If Growth Was The Current Driver, The Euro And Rate Differentials Would Be Moving Together If Growth Was The Current Driver, The Euro And Rate Differentials Would Be Moving Together Instead, we believe that worries regarding the U.S. tax plan may be playing a role in the euro's strength. Investors are worried of a repeat about the Obamacare repeal debacle. Now that Senators Cruz, Rand and Cotton want to add a provision to the tax bill that would eliminate Obamacare's individual mandates, investors worry that Senators McCain, Murkowski and Collins will down the bill. This is a valid concern, but we should not forget that this is only U.S. legal process, and that reconciliation of the House version and the Senate version of the bill will need to take place before it is finalized, suggesting the final bill proposed could be very different from the version currently being discussed. Bottom Line: The euro is unlikely to benefit from a risk-off environment if the current selloff in EM and high-yield bonds continues. The euro area's net international investment position is too small to suggest that fund repatriation by local investors will result in the euro being bid. In fact, the euro has rallied on a similar impulse that pushed EM assets and copper higher: Stronger global growth and Chinese stimulus. Thus, now that the euro is over-owned and overbought, any tightening in EM financial conditions is likely to hurt it as well. Long CAD/SEK: The Rationale Last week, we opened a long CAD/SEK trade. The rationale for this position is rather straightforward. To start, the SEK is a more pro-cyclical currency than the CAD. Our Global Growth Indicator has rolled over and, if history is any guide, when this global growth gauge weakens, this leads to a period of depreciation for the stokkie relative to the loonie (Chart I-12). Stefan Ingves's renewed leadership of the Riksbank makes this risk even more salient. Throughout his tenure, Governor Ingves has emphasized that the Swedish central bank would fight imported deflation. Weakening global growth should result in some deflationary forces in Sweden, even if the domestic economy is experiencing growing resource utilization pressures. Ingves will counterbalance these dynamics by keeping the SEK down. Also, over the past 10 years, when U.S. two-year rates have been rising relative to euro area short rates, CAD/SEK has appreciated (Chart I-13). This is simply because the Canadian economy is tied to the U.S., while Sweden's is tied to the euro area. Thus when U.S. rates rise, this tends to let the Bank of Canada hike as well without putting undue pressure on CAD/USD. The same relationship is true between Swedish and European rates. As such, the current upward bias in U.S. relative to euro area rates is creating an upward drift on Canadian relative to Swedish rates. Chart I-12Growth Rolling Over Leads ##br##To A Stronger CAD/SEK Growth Rolling Over Leads To A Stronger CAD/SEK Growth Rolling Over Leads To A Stronger CAD/SEK Chart I-13When The Fed Tightens Versus ##br##The ECB, CAD/SEK Rises When The Fed Tightens Versus The ECB, CAD/SEK Rises When The Fed Tightens Versus The ECB, CAD/SEK Rises Some key domestic factors are also favoring the CAD over the SEK. Canadian real retail sales have spiked, growing a record three percentage points faster than Sweden's. Moreover, this development has occurred despite a surge in the Swedish credit impulse relative to that of Canada. The relative credit impulse is now slowly moving in favor of the Canadian economy. If this continues, since the Canadian consumer is already roaring, it will support Canadian aggregate demand relative to Sweden's. With Canadian wages set to pick up as labor shortages intensify, this could stoke additional wage and inflationary pressures (Chart I-14). The BoC is thus likely to continue to hike even if Ingves is hampered by the ECB and EM. Finally, CAD/SEK is trading at a 5% discount to our relative intermediate-term timing model (Chart I-15). This kind of a discount has historically been associated with tradeable rebounds in the loonie relative to the stokkie. We believe that a risk-off period in global capital markets is the likely catalyst required to realize the good value currently present in this cross. Chart I-14Canada Will Experience Rising Wages Canada Will Experience Rising Wages Canada Will Experience Rising Wages Chart I-15CAD/SEK Trading At A Discount to Rates CAD/SEK Trading At A Discount to Rates CAD/SEK Trading At A Discount to Rates This trade is obviously not devoid of risks. The most salient one remains the renegotiation of NAFTA. As Marko Papic, our Chief Geopolitical strategist argues in a Special Report, large swaths of the U.S. population are not in favor of free trade, and feel they have not gained much from globalization. Low social mobility, high income inequality, stagnant middle-class wages and growing difficulty to access debt have fueled this sentiment.2 Since U.S. President Donald Trump and not Congress is ultimately in charge of trade relations between the U.S. and the rest of the world, Trump has much leeway to please his electorate. He can therefore repudiate NAFTA. Such a development would hurt Canada. Exports to the U.S. represent 20% of Canada's GDP. A large share of these exports, especially in the auto sector, could fall under a new trade regime. This means that net exports might become a drag on Canadian growth, but it also means that a lot of capex that should have materialized in Canada will instead be realized in the U.S. This would boost USD/CAD. However, as excess investment in the U.S. is a positive for U.S. rates, it would also lift the USD against the EUR. Considering EUR/USD has a negative 67.3% correlation with CAD/SEK, this would limit the damage to our long CAD/SEK trade created by NAFTA renegotiations. Bottom Line: CAD/SEK should benefit as global growth and global risk assets hit a snag in the coming months. Moreover, the Canadian economy continues to experience growing inflationary pressures, while the Riksbank is likely to prove ultra-sensitive to any weakness in EM. With CAD/SEK trading on the cheap side, such a development is likely to result in a tactical upswing in this cross. The biggest risk to this position is related to an adverse ending to NAFTA renegotiations. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, titled "Temporary Short-Term Risks", dated November 10, 2017, available at fes.bcaresearch.com 2 Please see Geopolitical Strategy Special Report, titled "NAFTA - Populism Vs. Pluto-Populism", dated November 10, 2017, available at gps.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 U.S. data was generally positive: PPI measures beat expectations, with the headline measure coming in at 2.8% and the core at 2.4%; Core CPI beat expectations, coming in at 1.8%, while headline inflation remained steady at 2%; Continuing jobless claims decreased to 1.86 million, however initial jobless claims increased to 249,000; Net long-term TIC flows increased to USD 80.9 bn, while total net TIC flows are negative at USD -51.3 bn; NFIB Business Optimum Index and the Philadelphia Fed Manufacturing Survey underperformed expectations, coming in at 103.8 and 22.7, respectively; There was, however, a generally bearish rhetoric for the USD this week due to perceived inability of President Trump's administration to push through tax reform. Nevertheless, stronger inflation should lift the dollar in the coming months. Report Links: It's Not My Cross To Bear - October 27, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 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 area data was generally positive: German GDP accelerated greatly, hitting an annual rate of 2.3%, although this was in line with expectations. However, the quarterly measure of 0.8% beat expectations of 0.6%; European GDP grew in line with expectations of 2.5% on an annual basis; Industrial production increased by 3.3%, beating expectations of 3.2%; CPI across the euro area stayed steady and in line with expectations, with core inflation slowing to 0.9%. Importantly, the euro area core CPI diffusion index is decelerating sharply; As expected, French unemployment increased to 9.7% from 9.5%. The euro experienced a strong week following the release of these data points. However, as we have iterated in the past, the appreciation in the euro has tightened financial conditions, which means that inflation is unlikely to increase much from current levels. Report Links: Temporary Short-Term Rates - November 10, 2017 Market Update - October 27, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 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 has surprised to the upside in Japan: Industrial production monthly growth was not as weak as expected, only weakening -1%. Meanwhile, yearly growth came in at 2.6%, an acceleration relative to last month. Gross domestic product annual growth also outperformed expectations, coming in at 1.4%. However it is worth to point out that growth slowed from a 2.6% reading last quarter. The yen has appreciated slightly this week, with USD/JPY rising by about 0.4%. Overall we continue to bearish on the yen against the dollar, given that interest rate differentials will continue to be the main determinants of this cross. On the other hand we are more bullish on the yen against commodity currencies like the NZD, given that we expect a temporary growth downshift is likely to cause commodity and EM plays to experience some downside. Report Links: Temporary Short-Term Rates - November 10, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 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: Consumer price inflation underperformed expectations, coming at 3%. Core inflation also surprised to the downside, coming in at 2.7%. However average hourly earnings surprised to the upside, coming in at 2.2%. It is important to note however, that this is a slowdown from last month's number of 2.3%. Moreover, retail sales growth outperformed expectations coming in at -0.3%. Nevertheless, this measure drop sharply from last month's reading of 1.3%. Overall, the GBP/USD has stayed relatively flat this week, while it has depreciated by about 1% against the euro. We believe that the upside for the pound against the dollar from here on is limited, as the BoE has very little incentive to hike any more than what is priced into the SONIA curve given that inflation seems to be stabilizing. Report Links: Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 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 suffered this week following a slew of mixed data: NAB Business Conditions improved to 21 from 14, but Business Confidence remained steady at 8; Westpac Consumer Confidence was negative at -1.7%; Wage growth remains depressed at 2% annually and 0.5% quarterly, underperforming the expected 2.2% and 0.7%, respectively; Melbourne Institute's Consumer Inflation Expectations declined to 3.7% from 4.3% in November; The participation rate dropped 10 bps to 65.1% and employment grew by only 3,700, below the expected 17,500. However, this was because the decline in part-time employment of 20,700 was offset by the increase in full-time employment of 24,300. While there were some positive developments in the labor market, wages remain depressed, pointing to ongoing underemployment within the economy. This is likely to leave the RBA to stay cautious. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 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 The New Zealand dollar has depreciated by almost 2% this week, as commodities and junk bonds have plunged. We continue to be bearish on this currency against both the dollar and then yen, as we expect a further deterioration in EM financial conditions. This is mainly due to 2 factors: First, monetary tightening in China should cause a worsening in financial conditions, which will weigh on growth and commodity producers. Moreover, market-based expectations of U.S. interest rates could experience some upside as U.S. inflation is slated to pick up. This will put upward pressure on the U.S. dollar, and thus, weigh on commodity prices. Nevertheless, we continue to be bullish on the NZD relatively to the AUD, as the Australian economy is much more sensitive to the dynamics described above. Report Links: Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 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 Canadian data has been positive: Manufacturing shipments increased by 0.5% on a monthly basis, beating expectations of -0.3% but they were weaker than the previous release of 1.6%; Foreign portfolio investment in Canadian securities increased to CAD 16.81 bn, above the expected CAD 10.68 bn and also beating the previous figure of CAD 9.77 bn. However, oil weaknesses weighed on the CAD this week. Furthermore, a lack of Canadian data meant that USD/CAD traded mostly off positive U.S. data, which further handicapped the CAD. Report Links: Market Update - October 27, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 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 The Swiss franc has continued to depreciate, with EUR/CHF surging by almost 1% this week. This cross is now roughly 2.5% away from the level at which it was when the Swiss National Bank took off its floor in early 2015. Overall we see very little indication that the SNB will let off their ultra-dovish monetary policy and currency intervention. Speaking with the government on Wednesday, the SNB's president Thomas Jordan said that the Franc is still "highly valued". Although there has been a slight improvement in price inflation and in economic activity, it still too tepid for central bankers to change policy significantly. Thus, the franc will continue to suffer downward pressure, due to FX market intervention. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 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: Gross domestic product growth outperformed expectations, coming in at 0.7%. Moreover core inflation also surprised to the upside, coming in at 1.1%, and increasing from last month's reading of 1%. However headline inflation underperformed substantially, coming in at 1.2% and decreasing from last month's reading of 1.6%. The krone has depreciated slightly against the dollar, as USD/NOK has risen by almost 0.6% this week. In spite of our positive view on oil, we continue to be bullish on USD/NOK, given that this cross is more sensitive to interest rate differentials than it is to oil prices. The Norwegian economy is still plagued with plenty of slack, thus the spread between U.S. and Norwegian rates will continue to widen. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 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 SEK had a dismal week due to downbeat data: Inflation slowed greatly to 1.7% from 2.1%, even underperforming the expected slowdown of 1.8%. In monthly terms, it contracted by 0.1%; Capacity Utilization fell in Q3 to 0.2% from 0.5%, indicating slack in the economy; The unemployment rate also rose to 6.3%; EUR/SEK traded near 10.0000, appreciating to levels reached last October. These data points will certainly be taken into account by the Riksbank, and a dovish tilt has most likely been priced in by the market. Close EUR/SEK trade Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights The current mini-upswing in the global mini-cycle started in May and is likely to end around January. On a 6-month horizon, lean against the rally in industrial metals. Equity investors should underweight Basic Resources, and especially Industrial Metals and Mining. The contrasting economic fortunes of Spain and Italy may switch. The peak bank credit impulse for Spain is almost certainly behind it, while for Italy it likely lies ahead. On this hope, we will dip our toes into a small pair-trade: long Italian BTPs versus French OATs. Feature Key to the medium-term behaviour of markets is the existence of what we call 'mini-cycles' in global activity. The evolution of these perpetual mini-cycles explains much of what has happened, what is happening, and what will happen, to financial markets both in Europe and more broadly. Chart of the WeekExpect A Trend-Reversal In The Metals Market Expect A Trend-Reversal In The Metals Market Expect A Trend-Reversal In The Metals Market Mini-cycles are not a hypothesis. They are an indisputable empirical fact. Just look at the global bond yield (Chart I-2), metal price inflation (Chart I-3), global inflation (Chart I-4), and the bank credit impulse (Chart I-5 and Chart I-6). The regular mini-cycles shout out at you! Furthermore, given that these clearly observed mini-cycles show the same half-cycle length of about 8 months, Investment Reductionism strongly suggests that there is a common over-arching driver. Chart I-2The Global Bond Yield Exhibits Mini-Cycles The Global Bond Yield Exhibits Mini-Cycles The Global Bond Yield Exhibits Mini-Cycles Chart I-3Metal Price Inflation Exhibits Mini-Cycles Metal Price Inflation Exhibits Mini-Cycles Metal Price Inflation Exhibits Mini-Cycles Chart I-4Inflation Exhibits Mini-Cycles Inflation Exhibits Mini-Cycles Inflation Exhibits Mini-Cycles Chart I-5The Global Credit Impulse Exhibits Mini-Cycles The Global Credit Impulse Exhibits Mini-Cycles The Global Credit Impulse Exhibits Mini-Cycles Chart I-6Individual Credit Impulses Exhibit Mini-Cycles Individual Credit Impulses Exhibit Mini-Cycles Individual Credit Impulses Exhibit Mini-Cycles Explaining Mini-Cycles Previously,1 we explained that the distinct mini-cycles are interconnected parts of the same never-ending feedback loop. A lower bond yield accelerates bank credit flows... which boosts economic growth... which pushes up commodity inflation and overall inflation... causing the bond market to raise the bond yield, at which point the cycle reverses. And then the alternate cycles repeat ad perpetuam (see Box I-1). Box I-1The Mathematics Of Mini-Cycles How To Profit From Mini-Cycles How To Profit From Mini-Cycles One common question we get is: why focus on bank credit analysis and not on bond-intermediated credit analysis too? The simple answer is that bank credit expands the broad money supply whereas bond-intermediated credit usually does not. When a bank issues a new loan, fractional reserve banking allows it to create money 'out of thin air'. In contrast, when a company or government issues a new bond, no new money is created, unless the primary issue is financed by the central bank - which is generally forbidden. Usually, when a bond is issued, existing money just moves from one account - that of the bond buyer - to another account - that of the bond issuer. This means that bond-intermediated credit cannot increase demand by creating new money, but only by increasing the velocity of existing money. Whereas bank credit can increase demand by increasing both the amount of money and its velocity. Therefore, changes in bank credit are the much bigger driver of the mini-cycle in economic activity. If a bank issues 100 euros of credit today, then we know that this new money will be spent in the coming days and weeks - because nobody borrows money just to sit on it. If, in the previous period, the bank had issued 90 euros which was spent, it means that economic activity in the coming period will grow by 10 euros. But if the bank had previously issued 110 euros, it means that economic activity in the coming period will contract by 10 euros. In this way, the cycles in credit and activity are interconnected. Mini-upswings in the credit impulse mini-cycle tend to signal mini-upswings in commodity inflation (Chart I-7), overall inflation and bond yields. So if we can identify turning points in the credit impulse then we can correctly position the cyclical stance of our investment strategy. Chart I-7The Same Mini-Cycle: The Global Credit Impulse And Metal Price Inflation The Same Mini-Cycle: The Global Credit Impulse And Metal Price Inflation The Same Mini-Cycle: The Global Credit Impulse And Metal Price Inflation The problem is that the bank credit data is slow to come out. For example, although we are in the middle of November, the last bank credit data for the euro area refers to September. This means that if the mini-cycle is turning now, we might not find out until January. Nevertheless, we can still use the mini-cycle framework. We know that the current mini-upswing started in May and that mini-upswings have an average length of 8 months. Hence, we can infer that the mini-upswing is likely to end around January. That said, upswing lengths do have some degree of variation: the current upswing might be longer or shorter than the average. How to avoid being too early or too late? Combining Mini-Cycles With Fractal Analysis To optimise our proprietary mini-cycle framework, we propose combining it with our proprietary fractal analysis framework. As regular readers know, fractal analysis measures whether herding in a specific investment has become excessive, signalling the end of its price trend. The combined mini-cycle and fractal framework works best if we use a 130-day herding indicator (fractal dimension), as it broadly aligns with the mini half-cycle length. Excessive herding signals that an investment's trend is approaching exhaustion because the liquidity that has fuelled the trend is about to evaporate. Liquidity is plentiful when the market is split between different herds - say, short-term momentum traders and long-term value investors. This is because the herds disagree with each other. If the price fluctuates up, the momentum trader wants to buy while the value investor wants to sell; and vice-versa. So the herds trade with each other with plentiful liquidity. But liquidity starts to evaporate when too many value investors join the momentum herd. Instead of dispassionately investing on the basis of value, value investors get sucked into chasing a price trend, and their buy orders add fuel to the trend. The tipping point comes when all the value investors have joined the momentum herd. If a value investor then suddenly reverts to type and puts in a sell order, he will find that there are no buyers left. Liquidity has evaporated, and finding new liquidity might require a substantial reversal in the price to attract a buy order from an ultra-long-term deep value investor. Earlier this year, our combined frameworks signalled that the aggressive rise in bond yields was likely to reverse (Chart I-8). Therefore, on February 2 we correctly advised: "Lean against the rise in bond yields and bank equities." Chart I-8Excessive Herding In Bonds Always Signals A Trend Reversal Excessive Herding In Bonds Always Signals A Trend Reversal Excessive Herding In Bonds Always Signals A Trend Reversal Today, we see the same dynamic in parts of the commodity rally - and specifically the move in the LME Index (Chart of the Week). Hence, on a 6-month horizon, lean against the rally in industrial metals. Equity investors should underweight Basic Resources, and especially Industrial Metals and Mining. Could Italy Be A Good Surprise? Returning to the concept of the bank credit cycle, the evolution of longer-term impulses also explains the contrasting recent fortunes of Spain and Italy. In 2013, Spain recapitalized its banking system and ring-fenced bad assets within a 'bad bank'. In effect, it finally did what other economies - most notably the U.S., U.K. and Ireland - had done several years earlier in response to their own housing-related banking crises. As Spanish banks' aggressive deleveraging ended, the bank credit impulse rebounded very sharply and has remained positive for several years. This undoubtedly explains why Spanish real GDP has grown by 13% since mid-2013 (Chart I-9). In contrast, Italy's banking system remained dysfunctional - which meant that its own credit impulse stayed much more muted and barely positive over the past four years (Chart I-10). But now, the Italian banking system is slowly recuperating. Italian banks' equity capital is rising, their solvency is improving, and the share of non-performing loans has fallen sharply this year. Chart I-9Spain's Peak Credit Impulse##br## Is Probably Behind It Spain"s Peak Credit Impulse Is Probably Behind It Spain"s Peak Credit Impulse Is Probably Behind It Chart I-10Italy's Peak Credit Impulse##br## Is Likely Ahead Of It Italy"s Peak Credit Impulse Is Likely Ahead Of It Italy"s Peak Credit Impulse Is Likely Ahead Of It So the contrasting economic fortunes of Spain and Italy may switch. The peak bank credit impulse for Spain is almost certainly behind it, while for Italy it likely lies ahead. On this hope, we will dip our toes into a small pair-trade: long Italian BTPs versus French OATs. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Please see the European Investment Strategy Weekly Report 'Credit Slumps While Animal Spirits Soar. Why?' March 30, 2017 available at eis.bcaresearch.com Fractal Trading Model* There are no new trades this week, leaving us with six open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 Short Nikkei225/Long Eurostoxx50 Short Nikkei225/Long Eurostoxx50 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch -##br## Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - ##br##Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch -##br## Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch -##br## Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights Question 1: Why is U.S. inflation still so low? Question 2: How important is the upcoming change in Fed leadership? Question 3: What are the implications of the U.S. tax cuts? Question 4: What is the outlook for the ECB next year, and how will this impact the U.S. dollar versus the euro? Question 5: Are markets underestimating the potential impact from slower growth of central bank balance sheets? Question 6: How much longer can this powerful rally in Emerging Markets continue? Question 7: What are other investors worried about? Feature I have just returned from an extended two-week trip visiting clients in the Asia-Pacific region. The meetings were all very well attended, with even many non-dedicated fixed income investors turning up to ask tough questions about global bond markets. My impression was that given the powerful returns earned in virtually all risk assets this year (equities, credit, Emerging Markets), our clients are growing more concerned about the potential risks from tighter global monetary policy and rising interest rates than they have been for some time. Oddly enough, this is despite not fearing either a serious rise in inflation or a major growth slowdown next year. If such a thing as "nervous complacency" can exist, it seemed widely evident in most of my meetings. This week, I am taking a more personal tone than in a typical Global Fixed Income Strategy Weekly Report to summarize the key client questions from ten days of meetings, spread across six cities in five countries on two continents. Why is U.S. inflation still so low? Chart 1Tightest Global Labor Market##BR##Since The Mid-2000s Tightest Global Labor Market Since The Mid-2000s Tightest Global Labor Market Since The Mid-2000s Almost all of the meetings began with a discussion of the current situation in the U.S., particularly the lack of inflation. The current BCA view that U.S. inflation will accelerate in 2018 was met with some skepticism, particularly when framed in the context of the uncertain unemployment/inflation trade-off. In one meeting, outright laughter actually broke out when the term "Phillips Curve" was mentioned! Clearly, the burden of proof is on the inflation data itself. On that note, I presented several of the best BCA charts from recent months that show how the backdrop is ripe for a turnaround in global inflation. Clients were impressed when shown that nearly ¾ of the countries in the OECD had unemployment rates below the full-employment NAIRU, a level not seen since the period of strong coordinated global growth and rising inflation in the mid-2000s (Chart 1). Yet when I then presented a chart showing the actual inflation/unemployment data in the U.S. over the past 20 years, with a clear "kinked" Phillips Curve and the latest data point well on the steeper portion of that curve (Chart 2), the majority of clients were less convinced. The most cited reason was that the U.S. inflation data simply did not accelerate in 2017 when it was supposed to given the steady fall in unemployment over the preceding few years. Perhaps most surprising was that, rather than believe that the NAIRU rate may simply be lower now than in past business cycles, so many people that I met were willing to discard the entire Phillips Curve concept as a useful framework to forecast inflation. When presented with charts showing non-Phillips Curve reasons to expect higher inflation, however, there was far less skepticism. Perhaps the most compelling chart showed the typical 18-month lag between U.S. economic growth and the "momentum" of U.S. inflation (Chart 3). Upon seeing this, clients were more convinced that inflation would pick up next year in response to the current U.S. growth upturn. Chart 2U.S. Economy Has Moved Into##BR##The "Steep" Part Of The Phillips Curve The Most Important Client Questions From A Long Road Trip The Most Important Client Questions From A Long Road Trip Chart 3Inflation Typically Follows Economic Growth With A Long Lag Inflation Typically Follows Economic Growth With A Long Lag Inflation Typically Follows Economic Growth With A Long Lag I was also able to break down some of the skepticism on the U.S. inflation outlook even more after discussing the bullish oil forecast from our colleagues at Commodity & Energy Strategy. Admittedly, their view that the benchmark Brent oil price will average $65/bbl in 2018 sounds far less dramatic given that the current spot price has risen to nearly that level in the aftermath of the recent political turmoil in Saudi Arabia. Yet clients did appreciate that our bullish oil call was driven more by a view of improving global oil demand and continued production discipline by oil producers (especially for the so-called "OPEC 2.0" nations of Russia and Saudi Arabia). When shown our chart describing how oil prices persistently in the mid-$60s next would put some upward pressure on the inflation expectations component of global bond yields (Chart 4), there was virtually no disagreement from any clients that I met. There was a bit more pushback on the view that, if the BCA forecast of higher U.S. inflation and rising oil prices in 2018 comes to fruition, there is room for a substantial rise in U.S. Treasury yields from current levels. When presented a chart showing that market-based inflation expectations (both using TIPS breakevens and CPI swaps) could rise by 50-60bps just to get back to levels consistent with the Fed's inflation target (Chart 5), most clients politely nodded and basically said "show me the actual inflation first." Although there was widespread agreement with our view that it would take that kind of move in inflation expectations to prompt the Fed to fully deliver on the 100bps of rate hikes it is currently projecting to occur over the next year. Chart 4A Boost To Inflation Expectations##BR##From Higher Oil In 2018 A Boost To Inflation Expectations From Higher Oil In 2018 A Boost To Inflation Expectations From Higher Oil In 2018 Chart 5The Normalization Of U.S. Inflation##BR##Expectations Will Continue The Normalization Of U.S. Inflation Expectations Will Continue The Normalization Of U.S. Inflation Expectations Will Continue How important is the upcoming change in Fed leadership? The vast majority of clients that I met asked about the BCA view on the nomination of Jerome Powell as the new Fed Chair, replacing Janet Yellen. My impression was that there was not a lot of concern over the potential for serious alterations to the future path of U.S. monetary policy under new leadership. Yet it was still potentially a big enough change to ask questions about it. Most clients agreed with the BCA view that a Fed Chair Powell will not act much differently than Yellen. His voting history has aligned with hers and, by his own admission, he is a very data dependent central banker given that he is not a formally-trained economist. Only by knowing the ins and outs of the data has he been able to debate successfully with the Ph.D economists on the FOMC. Powell will likely be a data-driven Fed Chair that would not look to hike rates without higher inflation (and vice versa). Chart 6A Communications Problem##BR##For Jerome Powell? A Communications Problem For Jerome Powell? A Communications Problem For Jerome Powell? One point that I raised in all the meetings was that the Fed's communication strategy on future rate increases is the more worrisome issue for financial markets at the moment. The U.S. money market curve is still priced for only 50bps of rate increases over the next year, while the Fed "dots" are signaling 100bps of hikes. We think the Fed will deliver on its projections, which is one of the reasons we are recommending a below-benchmark duration stance in the U.S. (the upside in inflation expectations is the other reason). More importantly, the Fed's so-called "terminal rate" projection is at 2.75%, while our proxy for the market pricing of that rate - the 5-year U.S. Overnight Index Swap rate, 5-years forward - is hovering just above 2% (Chart 6). The persistent disagreement between the market and the Fed over the appropriate level of the terminal rate will become a problem later in 2018 if the Fed does indeed raise the funds rate to over 2% and continues to signal that more rate hikes will come to get the funds rate up to "neutral" (the terminal rate). If the Fed is not able to change the market's mind about the appropriate neutral level of the funds rate, then a move to the Fed's estimated terminal rate of 2.75% would push U.S. monetary policy into what will would be perceived a restrictive stance. This would have implications for the shape of the U.S. Treasury curve (a lot flatter) and for future growth expectations (a lot slower) heading into 2019. My impression from my meetings was that this possibility - that the Fed could engineer what would look to the markets like a policy mistake simply by sticking to its forecasts - was not at the forefront of clients' thinking at the moment. Yet there was no disagreement with the logic of how that could play out. The new Fed leadership under Jerome Powell may have its hands full clearly explaining their policy decisions in 2018, which could create some turbulence in global financial markets later in the year. What are the implications of the U.S. tax cuts? The details of the tax plans from the U.S. House of Representatives and the U.S. Senate were a very hot topic in all of my client meetings. Considering all the ideas being proposed, from cuts in corporate tax rates to changes in the tax treatment of debt interest costs to removing the disincentive to repatriate profits earned abroad, it is no surprise that both equity and fixed income clients had a lot of questions on future U.S. tax policy. It is difficult right now to judge the net impact of the tax changes, as not all of the proposals in the two Congressional tax plans will likely be implemented. There will be plenty of horse trading between the Republicans and Democrats (and between the Republicans themselves) before the final tax deal is done. Yet there was a lot of concern among clients in my meetings over the likelihood that the tax cuts will be implemented at all. After seeing President Trump lose the battle on health care reform earlier this year, many clients were worried that a repeat could happen for the Trump tax cut agenda. This would have negative implications for U.S. equity markets, the U.S. dollar and future Fed policy moves. I explained the views from our colleagues at Geopolitical Strategy, who strongly believe that a tax cut will eventually pass (likely in early 2018) given the need for Congressional Republicans to have something positive to present to voters heading into the 2018 U.S. midterm elections. The tax cuts will have a moderate stimulative effect on the U.S. economy that the markets were not yet fully discounting. I also presented the chart from Global Fixed Income Strategy showing that wider U.S. budget deficits usually coincide with a steeper U.S. Treasury curve, almost always because the U.S. economy is slowing down, prompting looser fiscal policy and also Fed rate cuts (Chart 7). This time is different, however, since the Trump tax cuts will be stimulating an economy currently at full employment (middle panel). This has the potential to trigger more inflation through faster economic growth and even tighter labor markets which could prompt the Fed to move more aggressively on interest rate increases next year and eventually flatten the UST curve (bottom panel). Chart 7A Full-Employment Fiscal Stimulus Will Bear-Steepen The UST Curve A Full-Employment Fiscal Stimulus Will Bear-Steepen The UST Curve A Full-Employment Fiscal Stimulus Will Bear-Steepen The UST Curve The idea of a "steeper, then flatter" Treasury yield curve in response to U.S. fiscal policy stimulus generated a lot of discussion in my meetings. Some even noted that the recent flattening of the curve was a sign that the markets were discounting a lower probability of a tax deal being reached in D.C. I described the flat curve as a consequence of inflation expectations remaining too low, as the Treasury curve was much flatter than implied by the low level of the real fed funds rate, which is one of the most reliable relationships in the bond markets (higher real rates = a flatter curve, and vice versa). My conclusion from these meetings (and from the current market pricing) is that clients are a bit skeptical that a tax deal will be reached. This suggests there is room for bond yields to rise, and the Treasury curve to bear-steepen, if our political strategists are right and the tax cuts will happen. What is the outlook for the ECB next year, and how will this impact the U.S. dollar versus the euro? While most of the questions in my meetings focused on the U.S. outlook, several clients asked about the next move from the European Central Bank (ECB). This was both from a fixed income perspective and, perhaps even more importantly, with an eye on the future direction of the euro versus the U.S. dollar. I made the straightforward argument that with Euro Area economic growth showing strong momentum that is unlikely to slow much in 2018, and with headline Euro Area inflation likely to surprise to the upside based on our bullish oil call (Chart 8), the ECB would likely be forced to signal a tapering of its asset purchase program to zero by the end of next year. The oil view was especially important, as the ECB is expecting a slowing of headline Euro Area inflation to 1% in early 2018 based on the base effects from comparisons to the rise in oil prices seen in early 2017. If our house view on oil prices plays out, then there is potential for inflation to catch the ECB by surprise in 2018. The key will be how core inflation plays out as oil prices rise further. Core Euro Area inflation has dipped lower in recent months, even as wage growth has accelerated (bottom panel). Given tightening Euro Area labor markets, and robust domestic demand, the recent dip in core inflation is likely to bottom out sometime in the first few months of 2018. But until that happens, there is more potential for higher U.S. bond yields through faster increases in inflation expectations and Fed rate hikes (Chart 9). This will support a higher U.S. dollar versus the euro through wider interest rate differentials (bottom panel). Chart 8ECB Will Fully Taper##BR##By The End Of 2018 ECB Will Fully Taper By The End Of 2018 ECB Will Fully Taper By The End Of 2018 Chart 9UST-Bund Spread Will Widen Next Year,##BR##Supporting The USD UST-Bund Spread Will Widen Next Year, Supporting The USD UST-Bund Spread Will Widen Next Year, Supporting The USD Clients were generally in agreement with that view on relative interest rates, but the views on the direction of EUR/USD were far more mixed. My impression is that if the Fed delivers the rate hikes that we expect in 2018, EUR/USD has room to move lower as investors were not prepared for this. Are markets underestimating the potential impact from slower growth of central bank balance sheets? I received many questions on the potential impact of central banks either shrinking balance sheets (the Fed) or slowing their expansion (the ECB and Bank of Japan). The chart showing how the growth in central bank money printing since 2015 (when the ECB began buying bonds) has correlated strongly with the bull markets in virtually all global risk assets garnered a lot of attention (Chart 10). This was especially true when I showed the chart that converted the level of the major central bank balance sheets to a growth rate and plotted that versus the returns on global equities and credit markets (Chart 11). The implication - expect lower returns on global equity markets, and MUCH lower returns from corporate bond markets next year. Chart 10CB Liquidity Has Supported Risk Assets... CB Liquidity Has Supported Risk Assets... CB Liquidity Has Supported Risk Assets... Chart 11...But That Tailwind Will Fade Next Year ...But That Tailwind Will Fade Next Year ...But That Tailwind Will Fade Next Year On this point, there was almost no disagreement from clients. There is widespread awareness that this era of puny interest rates, spurred on by central banks buying up huge quantities of government bonds and other financial assets, was forcing investors to take on far more risk in their portfolios to achieve acceptable returns. The key is when this will all turn around. Clients were generally in agreement with my view that the final leg of this liquidity-driven global bull market in risk assets will best be played through equity markets over corporate credit. These stable, earnings-driven rallies seen in global equity markets have not yet reached a "blowoff" phase that would suggest a larger correction is imminent. Perhaps it will take a final asset allocation decision to move more money out of bonds into equities to trigger that final run-up in equity prices before tighter monetary policies and slower growth expectations begin to damage returns later in 2018 into 2019. How much longer can this powerful rally in Emerging Markets continue? This is a topic that generated a healthy amount of debate in my meetings, particularly given the bearish views on Emerging Market (EM) assets from my colleagues at Emerging Markets Strategy. Here again, clients were generally looking at EM as a way to achieve acceptable returns in their portfolios while also participating in the global economic upturn through growth-sensitive assets. The previous chart showing the impact of diminished central bank liquidity on EM credit markets got some clients a bit nervous about the outlook for EM markets. What also spooked them were the charts from our EM strategists showing accelerating Chinese inflation (Chart 12) and slowing Chinese money growth. There is obviously a connection between the two, as China's policymakers are being forced to tighten monetary policy, and clamp down on excess credit creation, in response to accelerating inflation and very high debt levels. The chart showing how our "China M3 Impulse" had turned negative this year and was pointing to slower growth in industrial metals prices and China capital goods imports (Chart 13) was particularly unnerving for even the most bullish of EM clients. Chart 12This Is Why China Is Tightening Monetary Policy This Is Why China Is Tightening Monetary Policy This Is Why China Is Tightening Monetary Policy Chart 13Prepare For Slower Chinese Growth In 2018 bca.gfis_wr_2017_11_14_c13 bca.gfis_wr_2017_11_14_c13 My impression is that the clients I met were fully loaded up on EM assets but were comfortable holding those positions based on expectations of solid Chinese economic growth and continued inflows into EM assets from yield-starved global investors. If BCA's view that Chinese growth will slow next year comes to fruition, combined with rising U.S. interest rates and a stronger U.S. dollar as the Fed tightens more than currently discounted by the markets, then there is potential for outflows from EM markets to accelerate, to the detriment of EM returns. What are other investors worried about? This is a question that comes up a lot at BCA meetings, as clients are always curious as to what we are hearing from other investors. Perhaps this can be chalked up to a version of "confirmation bias", where investors like to hear that their own views are shared by others in the markets. In my meetings over the past two weeks, however, I got the sense that clients are heavily exposed to risk assets, which have performed beyond their expectations, and are growing more worried about how things can go wrong. Like an end to the current low volatility regime, for example. Given the BCA views on the likelihood of global inflation increasing next year, triggering a more hawkish response from policymakers, I noted that I did not believe that clients were prepared for that outcome. This suggests that the beginning of the end of the current low volatility regime, which is seen across all asset classes (Chart 14), will occur through a pickup in bond volatility. This will take place from a rise in inflation expectations first, and a rise in policy rate expectations later. My advice to clients was that if realized bond volatility picks up, this is the signal to reduce exposure to credit and equity markets. We anticipate making such a recommendation sometime during 2018. Chart 14The Low Market Volatility Backdrop Will End When Bond Volatility Rises The Most Important Client Questions From A Long Road Trip The Most Important Client Questions From A Long Road Trip Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com The GFIS Recommended Portfolio Vs. The Custom Benchmark Index The Most Important Client Questions From A Long Road Trip The Most Important Client Questions From A Long Road Trip Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights A growing list of indicators is pointing to a potential slowdown to the strong global growth. However, the key deflationary anchors in the global economy - U.S. deleveraging, Europe's crisis, and Chinese excess capacity - have been mostly slayed. Any slowdown is likely to be brief and shallow, generating a buying opportunity in risk assets. In the meantime, commodity currencies, especially the AUD, could suffer. EUR/JPY is also at risk. Buy CAD/SEK. Feature Chart 1-1Global Growth Has Boomed Global Growth Has Boomed Global Growth Has Boomed Global growth has continued to fire on all cylinders, and global industrial activity is at its strongest in 13 years (Chart I-1). However, five weeks ago, we highlighted three yellow flags that we believe are pointing toward a period of cooling in the global economy.1 One month later, it is time to look at the data and evidences to see if these yellow flags are being followed by additional symptoms. We posit that yes, a temporary and mild slowdown will materialize. But the global economy remains fundamentally sound. Yet, this cooling of growth could have implications for commodity currencies and EM assets. The Original Worries The key original worry that we highlighted in early October was that global money growth had been decelerating, which has historically presaged a slowdown in global industrial production, global trade and commodities prices (Chart I-2). This deceleration in money growth has only deepened since, adding further saliency to our original concern. Moreover, Chinese monetary and fiscal conditions are being tightened. The Chinese economy continues to hum at a healthy pace, and deflation has been vanquished as producer prices are expanding at a nearly 7% pace and core CPI continues to accelerate to its highest levels since 2010. This is giving Chinese policymakers an opportunity to tighten policy. Chinese monetary condition indices (MCI) are becoming less supportive of industrial activity and fiscal spending has decelerated. These policy moves potentially explain the recent rollover in the Keqiang index - which approximates industrial growth -- and the contraction in new capex projects (Chart I-3). Chart I-2Money Growth Points To A Pause Money Growth Points To A Pause Money Growth Points To A Pause Chart I-3China Is Tightening Policy China Is Tightening Policy China Is Tightening Policy Bottom Line: Global money growth continues to decelerate, and Chinese monetary and fiscal conditions are tightening. This could create a dent in global industrial activity. The Additional Worries Some other key growth indicators are also raising the alarm bell: The average of Korean and Taiwanese exports growth decelerated sharply. After having hit a peak of 32% in September, they have now decelerated to 5%. Additionally, Swedish and Australian manufacturing PMIs have also rolled over (Chart I-4). Korean and Taiwanese exports as well as Swedish and Australian PMIs are highly sensitive to global trade and the global industrial cycle. Our global growth indicator has rolled over. This indicator did forecast the rebound in industrial production in 2016 and 2017. It is now pointing toward a slowdown in global activity (Chart I-5). Likewise, our boom/bust indicator has rolled over, further highlighting the risks to global industrial production (Chart I-6). Chart I-4Key Barometers Have Turned Significantly Lower Key Barometers Have Turned Significantly Lower Key Barometers Have Turned Significantly Lower Chart I-5One Growth Indicator Slowing... One Growth Indicator Slowing... One Growth Indicator Slowing... Chart I-6...And Another One Too ...And Another One Too ...And Another One Too BCA's German industrial production model has turned down (Chart I-7). Germany is at the forefront of the global industrial cycle, and its own industrial production is highly geared to global trade. This is because manufacturing represents 23% of Germany's output and Germany's exports account for 38% of GDP. Furthermore, 30% of German exports are destined to EM economies, the epicenter of the global secondary sector. Thus, if German IP weakens, it will reflect an ebbing in the global industrial cycle. The global yield curve has continue to flatten in recent weeks (Chart I-8). This could be a reflection of the deceleration in global money growth. The weakness of banks across the world in recent days suggests the message from the yield curve should not be ignored. Chart I-7Manufacturing-Sensitive Germany Set To Slow Manufacturing-Sensitive Germany Set To Slow Manufacturing-Sensitive Germany Set To Slow Chart I-8Global Yield Curve Still Flattening Global Yield Curve Still Flattening Global Yield Curve Still Flattening Bottom Line: Beyond the slowdown in global money growth and tightening in Chinese policy, additional signs of softness have begun to emerge. Korea and Taiwanese exports as well as Swedish and Australian PMIs have weakened, our global growth indicator has rolled over, our boom/bust indicator is also softening. Likewise, our German IP model is pointing south and the global yield curve is flattening. A deceleration in global activity is likely in the cards. Reading Market Tea Leaves A few market developments are likely to be reflecting some of the underlying shifts in growth pinpointed by the set of worries highlighted above. First, commodity currencies have begun to soften, which normally herald a period of softening growth (Chart I-9). What is very interesting is the context in which this currency weakness has begun to emerge: The Australian dollar has weakened despite strengthening metals prices (Chart I-10); Chart I-9The Message From Commodity Currencies The Message From Commodity Currencies The Message From Commodity Currencies Chart I-10Why Is The AUD Weak? Why Is The AUD Weak? Why Is The AUD Weak? The Canadian dollar has weakened despite Brent breaking out above US$60/bbl; The Norwegian krone has weakened against the euro despite the same rise in oil prices and despite a 12% surge in industrial production. Chart I-11Global High Yield Experiencing Weakness Global High Yield Experiencing Weakness Global High Yield Experiencing Weakness Second, the breadth of EM equities has rolled over and is falling below the zero line, indicating that more stocks within EM have begun weakening than appreciating, pointing toward a very narrow participation in the current rally. Third, junk bond prices have started to fall in the U.S., with the JNK ETF breaking significantly below its 200-day moving average, the first time since September 2014. EM high yield bond prices have also broken below their moving average, and have further punched below a key upward sloping trend line that had been in place since the beginning of 2016 (Chart I-11). The EM bond ETF (EMB) is also testing its 200-day moving average. The last point bears particular significance. If EM bonds continue to weaken, this will represent a significant tightening in EM financial conditions. EM financial conditions have eased since 2016, which was a key factor underpinning the improvement in global IP. If EM financial conditions begin deteriorating now, a crucial support to the global economy will dissipate. Moreover, falling EM bond prices tend to be synonymous with falling EM exchange rates. In fact, the Russian ruble, the Turkish lira, the South African rand, the Brazilian real and the Mexican peso have all been weakening since the end of the summer. This suggests outflows out of these markets have begun. As investors pull money out of these markets, liquidity conditions in these economies will tighten, which will hurt their economic activity. This could be the mechanism that catalyzes the softening in global industrial activity highlighted above. All these developments are also emerging at a time when new, untested leadership will soon take hold of the Federal Reserve. Now that U.S. President Donald Trump has selected Jay Powell to helm the Fed, he still has three seats to fill on the board. Historically, transition periods at the Fed can be associated with market volatility. This time around may not be an exception. Bottom Line: Commodity currencies are weakening, market breadth in EM equities is deteriorating rapidly and junk bonds as well as various EM fixed income products are experiencing weakness. Not only do these developments tend to foreshadow ebbing global industrial activity, the weakness in EM bonds could in of itself tighten financial and liquidity conditions. The latter has been a key driver of the global industrial cycle. This represents a potentially dangerous environment. How Dangerous Exactly? Chart I-12Global Utilization Not##br## Deflationary Anymore Global Utilization Not Deflationary Anymore Global Utilization Not Deflationary Anymore All of this sounds very dire, but the reality is more nuanced. This softness in economic activity is unlikely to be very pronounced. As we argued last week, the three key factors that have created a strong deflationary anchor in the global economy seem to have been vanquished: U.S. deleveraging is over, the euro area has healed as banks have been cleaned up, and Chinese excess capacity has been purged.2 As a result of these developments, global capacity utilization is in a much better spot than it was in 2015 (Chart I-12). This means the deflationary impulse likely to emerge out of the dynamics described above should be much more muted than it was two years ago. Moreover, commodities markets are not as oversupplied as they once were; in fact, oil inventories are falling as the OPEC 2.0 setup is proving stable. This implies that commodities prices are unlikely to weaken as much as they did back then. This obviously corroborates the idea that the deflationary impact of this slowdown is likely to be smaller and also suggests that the impact on global capex should be more muted. Thus, since growth and inflation are likely to prove more resilient than in 2015, the impact on asset prices of the slowdown is likely to be short lived. If anything, it is likely to provide a buying opportunity in risk assets. Some markets are more out of line with fundamentals than others, which implies that they will suffer more. Below, we discuss key tactics that could be used to navigate this environment. Bottom Line: Because the U.S. deleveraging is over, the euro area has healed and because Chinese excess capacity has been curtailed, the global economy is less prone to deflationary tendencies than two years ago. This means that any growth slowdown will be shallow and brief. Thus, only in the assets most mispriced or most exposed to the risks above will there be playable moves that we will seek to exploit. The relevant currency market implications are explored below. Investment Implications The most mispriced asset in the face of this potential slowdown in global growth seems to be EM equities. EM stocks are very sensitive to the global industrial cycle and EM financial conditions. Both are set to deteriorate. Moreover, since 2008, EM stocks have traded closely with junk bonds, but currently EM equity prices seem very pricey relative to U.S. high yield bonds (Chart I-13). Weakening EM stock prices continue to be a negative for commodity currencies, as it implies a slowdown in global industrial activity. Moreover, commodity currencies remain over-owned. As Chart I-14 illustrates, speculators are very long "risky currencies" versus "safe currencies," implying that a slowdown in global growth, however minute it may be, is likely to be a negative shock for these investors. When these relative net speculative positions roll over, it tends to be associated with violent weakness in commodity currencies. Thus, the recent bout of weakness could only be the first innings. We think the AUD is the worst-placed commodity currency right now. Not only are speculators very long the Aussie, but as we have shown in recent weeks, the AUD is expensive against the USD, the NZD and the CAD. Its premium is so pronounced relative to other commodity currencies that, at current levels, valuations alone warrant shorting the AUD against the CAD or NZD. We are already short these crosses. It therefore follows that if we anticipate commodity currencies in general to weaken, AUD/USD also has downside. Chart I-15 makes this case. Australian equities relative to U.S. equities have historically led AUD/USD. Nearly half of the Australian equity market is financials, and Australian equities have been underperforming. This suggests investors continue to foresee a negative output gap in Australia both in absolute terms and relative to the U.S. - and thus a dovish Reserve Bank of Australia relative to the Fed, which hurts AUD/USD. Moreover, AUD/USD has overshot the mark implied by relative equity prices. Additionally, AUD/USD is expensive relative to interest rate differentials at both the short- and long-end of the yield curve. Chart I-13EM Stocks Offer##br## No Cushion EM Stocks Offer No Cushion EM Stocks Offer No Cushion Chart I-14Speculators In Commodity ##br##Currencies Are Not Ready Speculators In Commodity Currencies Are Not Ready Speculators In Commodity Currencies Are Not Ready Chart I-15AUD Is Most ##br##Vulnerable AUD Is Most Vulnerable AUD Is Most Vulnerable The euro could also experience some weakness. We have argued that as European financial conditions tighten relative to the U.S., this will hurt euro area inflation relative to the U.S., pointing to an environment where investors will likely once again price in monetary divergences in favor of the USD.3 Growth dynamics between Europe and the U.S. could also be affected by the tightening in China. As Chart I-16A and Chart 16B illustrates, tightening Chinese MCI or slowing Chinese M1 relative to M2 - which proxies a faster growth in savings deposits than checking deposits, and thus a rising marginal propensity to save tends to translate into slowing PMIs and industrial production in the euro area relative to the U.S. This is because Europe has a larger manufacturing sector and export sector as a share of GDP than the U.S. German exports, Europe's growth locomotive, are also highly geared to the Chinese industrial sector. Thus, when Chinese investment slows, Europe feels it more acutely than the U.S. With investors still very long the euro relative to the USD, a negative relative growth surprise on top of a negative relative inflation surprise will hurt EUR/USD. Chart I-16AEuro Area Versus U.S. Growth: ##br##Don't Ignore China (I) Euro Area Versus U.S. Growth: Don't Ignore China (I) Euro Area Versus U.S. Growth: Don't Ignore China (I) Chart I-16BEuro Area Versus U.S. Growth: ##br##Don't Ignore China (II) Euro Area Versus U.S. Growth: Don't Ignore China (II) Euro Area Versus U.S. Growth: Don't Ignore China (II) The picture for the yen is more complex. Falling EM assets and a temporary growth slowdown are positive for the yen. But bond yield differentials remain the key driver of USD/JPY. Since we anticipate the global growth slowdown to be shallow and brief, any weakness in U.S. bond yields will also be shallow and brief. Since we expect U.S. bond yields to regain vigor fast, and we doubt the global slowdown will affect the Fed's path much, the effect on USD/JPY will also be quick. Thus, we are keeping our cyclical long bet on USD/JPY. In fact, a positive U.S. inflation surprise is a growing risk that could cause bonds to sell off, hurting global liquidity conditions in the process. Chart I-17EUR/JPY: Ripe For A Correction EUR/JPY: Ripe For A Correction EUR/JPY: Ripe For A Correction Instead, we will hedge our long USD/JPY exposure by tactically shorting EUR/JPY. Japan will also suffer from a slowdown in global industrial activity, especially as 43% of its exports are shipped to emerging markets. Moreover, Japan has a very large manufacturing sector. However, Japanese yields have no downside from here. This means the deflationary impact of a global growth slowdown, however small it may be, will weigh on Japanese inflation expectations more than it will hurt nominal rates, resulting in higher Japanese real rates.4 This support for the JPY is likely to get magnified in EUR/JPY. Currently, speculators have been massive buyers of the euro against the yen, betting on growing monetary divergence between Europe and Japan. This has pushed net speculative positions in the euro versus the yen to levels historically associated with a reversal in this cross (Chart I-17). This pair is thus a coiled spring in the face of the risk that Japanese real rates rise against European ones, especially if investors begin pushing back expectations surrounding the first ECB rate hike. Investors have already given up hope of any tightening of policy in Japan in the foreseeable future, implying a very minimal chance of them pricing in any easing by the Bank of Japan in response to a temporary global growth slowdown. The last factor supporting shorting EUR/JPY is that Japan has a net international investment position of 60% of GDP, while Europe's NIIP stands at -3% of GDP. Also, Japanese investors have been aggressive buyers of European assets, especially since Emanuel Macron secured the French presidency, causing a positive reassessment of European political risk. In an environment where global volatility increases, Japanese investors are likely to retreat to their home market, accentuating EUR/JPY selling. Finally, CAD/SEK is likely to benefit in this environment as well, as Sweden is more exposed to EM conditions than Canada is. We are buying this cross this week, but we'll explore the reasoning behind it in greater detail next week. Bottom Line: Commodity currencies are likely to be the main casualty of the slowdown we expect to occur over the next 3 to 6 months. The AUD seems particularly vulnerable as it is expensive and investors are still very long this currency. USD/JPY could experience some downside, but we do not anticipate the growth slowdown to be strong enough to permanently knock Treasury yields off their course toward 3%. Instead, we will short EUR/JPY to protect our gains in our long USD/JPY. CAD/SEK has upside. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Melanie Kermadjian, Senior Analyst melanie@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, titled "The Best Of Possible Worlds?" dated October 6, 2017, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report, titled "Reverse Alchemy: How To Transform Gold Into Lead" dated November 3, 2017, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report, "All About Credit" dated October 20, 2017, available at fes.bcaresearch.com and Foreign Exchange Strategy Weekly Report, "Are Central Banks Behind the Curve Or Ahead of It?," dated July 21, 2017, available at fes.bcaresearch.com 4 For a more detailed discussion of the interplay between growth and the yen, please see Foreign Exchange Strategy Weekly Report, titled "Down The Rabbit Hole" dated April 15, 2016, 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 U.S. data was mixed: Initial and continuing jobless claims underperformed expectations coming in at 1.901 mn and 239,000 respectively; JOLTS job openings climbed to 6.093 mn, beating expectations of 6.091 mn, and more than the previous 6.09 mn openings; Consumer credit increased to USD 20.83 bn from USD 13.14 bn, also beating expectations of USD 18 bn. The DXY enjoyed an up week, but a large spike in German Bund yields on Thursday caused the DXY to weaken. This is most likely a temporary event prompted by the unwinding of dovish ECB trades. We expect the greenback to continue its climb alongside stronger U.S. data. Report Links: It's Not My Cross To Bear - October 27, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 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 European data has generally been upbeat: The German trade balance and current account improved to EUR 21.8 bn and EUR 25.4 bn, but this first and foremost reflected a 1% contraction in imports; French trade balance also improved to EUR -4.668 bn, beating expectations of EUR -4.8 bn; European retail sales increased by 3.7% on a yearly basis, and 0.7% monthly; However, German industrial production growth slowed to 3.6%. This allowed the euro to regain some of its lost value. However, we believe that euro area inflation will disappoint going forward - especially relative to the U.S. This will limit any appreciation in the euro as investors will begin pricing in a tightening of the Fed's policy relative to the ECB. Report Links: Market Update - October 27, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 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 Japanese data has surprised to the downside: Core machinery orders massively underperformed expectations, as they contracted by 8.1% on a month-on-month basis and by 3.5% on an annual basis. Moreover, bank lending yearly growth also underperformed, coming in at 2.8%, and declining from last month's reading. Moreover, the leading economic indicator came below expectations, at 106.7. It also declined from last month's number. After 2 years into the recovery from the 2015 commodity/ EM carnage, global growth seems prime for some slowdown. Indeed, many indicators like high yield and EM bond yields have started to break down. This is could be positive for the yen, given its risk-off currency status. However we prefer to not play this strength though USD/JPY. Instead we are shorting EUR/JPY, a cross which cancels the exposure to the dollar. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day -August 25, 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 Services PMI outperformed expectations, coming at 55.6. It also increased from 53.6 last month. Halifax House Prices Month-on-Month growth also outperformed, coming in at 0.3%. However, the RICS Housing Price Balance underperformed expectations, coming in at 1%. The pound has been relatively flat after plunging following the "dovish" hike by the Bank of England. Overall, we see very little upside from here on for cable, as the BoE has little incentive to hike beyond what is priced into the SONIA curve, as both consumer confidence and real retail sales yearly growth are near 3-year lows. Meanwhile, the Fed will likely surprise the market by following its projected path. This will increase rate differentials between these two countries, and put downward pressure on GBP/USD. Report Links: Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 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 It has been quite an uneventful week for the AUD, as it has stayed flat relative to the USD. The following data came out: TD Securities Inflation increased to 2.6% from 2.5% on a yearly basis, and 0.3% on a monthly basis; ANZ Job Advertisements increased by 1.4% in September; AiG Performance of Construction Index declined to 53.2 from 54.7; Home loans contracted b 2.3%. The RBA rate decision and statement were in line with expectations, and the AUD saw little to no movement. Governor Lowe identified several capacity issues with the economy, noting that "In underlying terms, inflation is likely to remain low for some time, reflecting the slow growth in labour costs and increased competitive pressures", and that inflation is only being boosted by tobacco and electricity. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 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 On Wednesday, New Zealand decided to keep its reference rate unchanged at 1.75%. The kiwi rose after the announcement, as the Reserve Bank of New Zealand brought forward their expectations for a hike from the third quarter of 2019 to the second quarter of 2019. Furthermore, the RNZ now expects inflation to hit the mid-point of its target range by the second quarter of 2018, nine months sooner than before. The RBNZ also toned down its rhetoric on the currency as governor Grant Spencer stated that "the exchange rate has eased since the August statement, and if sustained, will increase tradable inflation and promote more balance growth". Overall we expect the NZD to outperform the AUD. Report Links: Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 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 Data in Canada has been positive: Ivey PMI moved up to 63.8 from 59.6, also outperforming the expected 60.2; Housing Starts increased by 222,800 annually, beating expectations of 210,000; Building permits also increased by 3.8% on a monthly basis; The most recent Business Outlook Survey report indicates that more than 40% of the surveyed businesses believe the shortage of labor has become worse, which is usually a reliable indicator of wage growth. This will allow the BoC to continue on its hiking path next year, which will mean that CAD will outperform other G10 currencies. NAFTA negotiations remain the greatest risk to the BoC view and the CAD. Report Links: Market Update - October 27, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 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: Headline inflation underperformed expectations, coming in at 0.7%. It stayed constant from last month's number. Meanwhile, unemployment was unchanged from last month at 3.1%. This number was in line with expectations. After peaking in late October, EUR/CHF has depreciated slightly, mainly due to the weakness in the euro. However, betting for CHF strength still means fighting against the SNB. Inflation in Switzerland is still too tepid for the SNB to stop their interventions in currency markets. Meanwhile, real retail sales yearly growth is still in negative territory. Thus, until we see a significant improvement in economic activity in the alpine country, we are reluctant to bet against the SNB. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 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: Registered unemployment declined from 2.5% in September to 2.4% in October However, industrial production surged to more than 12% on an annual basis Since the Norges Bank policy statement at the end of October, USD/NOK has been flat. This has been because this cross has been squeezed between two conflicting forces: On one hand, oil has gone up nearly 5% just this month. On the other hand, the rise in the dollar has counteracted any downside that rising oil prices could provide to USD/NOK. Although we continue to be bullish on oil, we are bullish on USD/NOK, as this cross is more correlated to real rate differentials than it is to oil. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 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 Swedish data was positive this week: Industrial production's monthly growth increased to 2.2% from a 1.6% contraction; the yearly measure is growing at a 4.5% pace, albeit less than the previous 7.5%; New orders are increasing at a very high 11.2% annual pace, a good forward-looking indicator for industrial production. While the Swedish economy remains robust, the SEK will see some downside against the USD and the EUR due to the Riksbank's dovishness. Also, the recent dip in EM high yield bonds could be a risk for the Swedish economy. We are therefore opening a long CAD/SEK trade. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights The so-called 'Silver Tsunami' of retiring baby boomers will continue to be a drag on aggregate wage growth for some time. We would strongly bet against the two further rate hikes that the Bank of England has flagged for this tightening cycle. Overweight U.K. 10-year gilts versus German 10-year bunds; and underweight GBP/EUR. The global inflation mini-cycle will turn down in early 2018. Approaching the year end, use technical opportunities to trim exposure to commodities, commodity equities and commodity currencies. Feature Last week, the Bank of England pointed out that "some of the softness in recent pay outturns had related to the composition of employment, with the number of low-paid jobs growing disproportionately."1 Separately, a recent study by the Federal Reserve Bank of San Francisco described the exact same phenomenon in the United States. "The drag on wage growth reflects changes in workforce composition."2 The San Francisco Fed study highlighted two paradoxes. The first paradox is that for continuously full-time employed workers, wages are actually rising quite strongly. For the continuously employed, pay is growing close to the rate seen at the previous economic peak in 2007 (Chart I-2). Chart of the WeekThe Inflation Mini-Cycle Will Turn Down In Early 2018 Will The Real Wage Inflation Please Stand Up Will The Real Wage Inflation Please Stand Up Chart I-2Will The Real Wage Inflation Please Stand Up Will The Real Wage Inflation Please Stand Up Will The Real Wage Inflation Please Stand Up However, the entry of new and returning workers to full-time employment continues to depress aggregate wage growth - because new entrants generally earn less than workers who are leaving full-time employment. This creates the second paradox. Strong job growth can actually pull down average wages in the economy and slow the pace of aggregate wage growth. Solving The Wage Puzzle According to the San Francisco Fed, this 'composition effect' is exceptionally pronounced right now because of the large-scale exit of higher-paid baby boomers from the labour force. This has depressed aggregate wage growth by 2 percentage points, a sizeable effect relative to the normal expected wage gains. Furthermore, with so many of the baby boomer generation still approaching retirement, "the so-called Silver Tsunami will continue to be a drag on aggregate wage growth for some time." A second very important factor is at play. The current wave of technological progress is having its most disruptive impact on middle-income jobs. As we explained in Why Robots Will Kill Middle Incomes,3 "high-level reasoning - such as logic and algebra - requires very little computation, but supposedly low-level sensorimotor skills - such as mobility and perception - require vast computational resources." The upshot is that when baby boomers retire, automation and Artificial Intelligence (AI) are replacing many of the jobs that the boomers occupied in high-income and middle-income sectors such as Finance and Manufacturing, rather than opening up these formerly lucrative career paths to new entrants. Therefore, new entrants are flooding into industry sectors which AI cannot yet disrupt but which are traditionally much lower paid with limited prospects for advancement - sectors like Food Services and Drinking Places and Administrative and Support Services (Table I-1). Table I-1Which Sectors Are Creating The Most Jobs? Will The Real Wage Inflation Please Stand Up Will The Real Wage Inflation Please Stand Up In summary, for the continuously employed, wages are rising healthily. But for aggregate wage growth, the composition effect from retirements and new entrants is an exceptionally strong headwind. What does this mean for overall inflation? The study concludes that as long as the economy can keep its wage bill low by replacing retiring staff with AI and with lower-paid workers, "labour cost pressures for higher price inflation could remain muted for some time." Given that the next wave of AI is just about to hit us, we expect these conditions to hold true in all developed economies for at least the next five years. Solving The U.K. Productivity Puzzle Chart I-3Since The Global Financial Crisis U.K. ##br##Productivity Has Stagnated Will The Real Wage Inflation Please Stand Up Will The Real Wage Inflation Please Stand Up But the San Francisco Fed study does also carry a warning about a latent inflationary threat. If productivity growth is slowing, "continued increases in unit labour costs could be hiding behind low readings on measures of aggregate wage growth." This seems to be a particular worry in the U.K. Since the global financial crisis, serial disappointments in productivity growth have concerned the Bank of England (Chart I-3). However, the Bank need not worry. We would like to present a very simple explanation for the U.K.'s so-called 'productivity puzzle'. Big clues come from comparing and contrasting the economic recoveries of 1993-2000 with 2009-17. At the very beginning of the two recoveries, productivity growth evolved in the same way. But then it took drastically different paths. Through the late 1990s, productivity growth accelerated, whereas through the 2010s productivity has stagnated. Why? A plausible explanation comes from the mirror-image patterns in self-employment. At the very beginning of the two recoveries, self-employment evolved in the same way. But through the late 1990s self-employment fell by 300,000, whereas through the 2010s self-employment has increased by a million, accounting for 30% of all jobs created (Chart I-4, Chart I-5, Chart I-6, Chart I-7). Furthermore, there is a tell-tale pattern. Whenever self-employment has picked up most sharply - for example, 2011-13 and 2015 - productivity growth has taken a big hit. Chart I-41990s Recovery: ##br##Self-Employment Fell Will The Real Wage Inflation Please Stand Up Will The Real Wage Inflation Please Stand Up Chart I-52010s Recovery: Self-Employment ##br##Has Risen Sharply Will The Real Wage Inflation Please Stand Up Will The Real Wage Inflation Please Stand Up Chart I-6Compare And Contrast: ##br##The Pattern of Self-Employment... Will The Real Wage Inflation Please Stand Up Will The Real Wage Inflation Please Stand Up Chart I-7...And Productivity...##br##Are Mirror-Images Will The Real Wage Inflation Please Stand Up Will The Real Wage Inflation Please Stand Up What's going on? Contrary to popular belief, the self-employed are not innovative entrepreneurs, who might typically boost productivity. The Office for National Statistics itself has poured cold water on the increased innovation thesis, claiming that "while there has been an increase in the number of people who are self-employed there has been a reduction in the number of employees who work for the self-employed." Given that these new self-employed work for themselves with no employees of their own, the idea that they are innovative entrepreneurs is a long way from the truth. In reality, the new model army of self-employed consists of former employees in sectors like journalism, media and technology who are now freelancing. And this provides a simple explanation for the productivity puzzle. Job creation that is skewed to self-employment depresses productivity growth. The reason is that the army of self-employed have to carry out tasks in which they have no specialism, and in which they are therefore much less productive. For example, a freelance journalist must spend time managing her IT gremlins, accounts, sales pitches, and so on, rather than focussing entirely on her special skill of writing powerful news stories. This makes her much less productive as a freelancer than as an employee. However, this hit to productivity eventually abates in one of two ways: freelancers gradually become more adept at the new tasks they must undertake; or more likely, they switch back to employee jobs in which they are much more productive. Combining the messages from the first two sections, the Bank of England need not fear labour cost pressures for higher price inflation. Furthermore, with Brexit negotiations progressing at a snail's pace, U.K. based companies are getting increasingly nervous about what their future international trading relationships will look like. So we would strongly bet against the two further rate hikes that the Bank of England has flagged for this tightening cycle. The investment conclusion is to overweight U.K. 10-year gilts versus German 10-year bunds; and underweight GBP/EUR. The Inflation Mini-Cycle Will Turn Down In Early 2018 Last week, we reviewed our mini-cycle framework for the global economy. To recap, the acceleration and deceleration of global bank credit flows - as measured in the global credit impulse - exhibits a remarkably regular wave like pattern with each half-cycle lasting about 8 months. As the current mini-upswing started in May, we are likely more than half way through the mini-upswing - with an expected end around January/February 2018. At which point, the cycle will enter a mini-downswing. The mini-cycle framework is so powerful that it also perfectly explains the mini-cycles in commodity price inflation - specifically, metals - and unsurprisingly, in overall inflation too. To anybody who still doubts the existence of these remarkably regular mini-cycles, the Chart of the Week and Chart I-8 should put the doubts to rest once and for all. Chart I-8Metal Price Inflation Also Exhibits Remarkably Regular Mini-Cycles Will The Real Wage Inflation Please Stand Up Will The Real Wage Inflation Please Stand Up Make no mistake. The mini-cycle in commodity prices and overall inflation will turn down in early 2018. So as we approach the year end, use technical opportunities to trim exposure to commodities, commodity equities and commodity currencies. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 From the Monetary Policy Summary and minutes of the Monetary Policy Committee meeting ending on November 1, 2017. 2 From the SF Fed blog 'The Good News on Wage Growth' August 14. 2017. 3 Please see the European Investment Strategy Special Report 'Why Robots Will Kill Middle Incomes' August 10, 2017 available at eis.bcaresearch.com. Fractal Trading Model* The near 20% rally in Japan's Nikkei 225 since early September has taken its 65-day fractal dimension to its lower bound, suggesting a likelihood of a trend-change. So our recommended trade this week is short Nikkei 225 / long Eurostoxx50 with a profit target / stop loss set at 3%. We now have six open trades. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-9 Will The Real Wage Inflation Please Stand Up Will The Real Wage Inflation Please Stand Up The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Will The Real Wage Inflation Please Stand Up Will The Real Wage Inflation Please Stand Up Chart II-2Indicators To Watch - Bond Yields Will The Real Wage Inflation Please Stand Up Will The Real Wage Inflation Please Stand Up Chart II-3Indicators To Watch - Bond Yields Will The Real Wage Inflation Please Stand Up Will The Real Wage Inflation Please Stand Up Chart II-4Indicators To Watch - Bond Yields Will The Real Wage Inflation Please Stand Up Will The Real Wage Inflation Please Stand Up Interest Rate Chart II-5Indicators To Watch -##br## Interest Rate Expectations Will The Real Wage Inflation Please Stand Up Will The Real Wage Inflation Please Stand Up Chart II-6Indicators To Watch -##br## Interest Rate Expectations Will The Real Wage Inflation Please Stand Up Will The Real Wage Inflation Please Stand Up Chart II-7Indicators To Watch -##br## Interest Rate Expectations Will The Real Wage Inflation Please Stand Up Will The Real Wage Inflation Please Stand Up Chart II-8Indicators To Watch - ##br##Interest Rate Expectations Will The Real Wage Inflation Please Stand Up Will The Real Wage Inflation Please Stand Up

Highlights Three factors point to stable or narrower USD cross-currency basis swap spreads: the improving health of global banks, the end of the adjustment to the regulatory change affecting prime-money market funds, and the relaxation to the Supplementary Leverage Ratio rules by the U.S. Treasury. Four factors point to wider basis swap spreads: BCA's forecast that U.S. loan growth will pick up, our view on U.S. inflation, the coming decline in the Federal Reserve's balance sheet, and the potential for U.S. repatriation. We expect USD basis swap spreads to widen again, which suggests increasing FX vol. This would hurt carry trades, EM currencies and dollar bloc currencies. Feature The rather arcane topic of cross-currency basis swap spreads has periodically surfaced in the news in the past few years. The widening in cross-currency basis swap spreads has been highlighted as one of the key factors explaining why covered interest rate parity relationships (the link between the price of FX forward, spot prices and interest rate differentials) have not held as closely after the Great Financial Crisis (GFC) as before. The widening of cross-currency basis swap spreads has also been highlighted as a factor behind the strength in the U.S. dollar in 2014 and 2015. Similarly, the recent narrowing in the cross-currency basis swap spread has been highlighted as a factor behind the weakness in the USD this year. This week we delve a little deeper into what cross-currency basis swap spread measures, and what some of its major determinants are. We ultimately expect the USD cross-currency basis swap spread to widen again, which should contribute to a stronger dollar and increased global FX volatility. What Is A Cross-Currency Basis Swap? To examine what drives cross-currency basis swap spreads, one first needs to understand what these instruments are. Let's begin with a regular FX swap. An FX swap in EUR/USD is a contract through which two counterparties agree to exchange EURs for USDs today, with a reversal of that exchange at the maturity of the contract - a reversal set at a predetermined exchange rate simply equal to the forward value of the EUR/USD. So, if counterparty A lends X million EURs to counterparty B, the former receives in U.S. dollars the equivalent of X million EURs times the prevalent EUR/USD spot rate from counterparty B today. The transaction does not end there. Simultaneously, the FX swap forces B to give back the X million EURs to counterparty A at maturity, while counterparty A gives back X million EUR times the EUR/USD forward rate in U.S. dollars to counterparty B. This forward rate is the rate prevalent when the contract was agreed upon. The transactions are illustrated in the top panel of Chart 1. Chart 1FX Swaps Vs. Cross Currency Basis Swaps It's Not My Cross To Bear It's Not My Cross To Bear The problem with regular FX swaps is that they offer little liquidity at extended maturities. If market players want to hedge long-term liabilities and assets, they tend to do so using a cross-currency basis swap, where much more liquidity is available at long maturities. A EUR/USD cross currency basis swap begins in the same way as a regular FX swap: counterparty A lends X million EURs to counterparty B, and the former receives in U.S. dollars the equivalent of X million EURs times the prevalent EUR/USD spot rate from counterparty B today. However, this is where the similarities end. A cross-currency basis swap has exchanges of cash flows through its term. Counterparty B, which provided USDs to counterparty A, receives 3-month USD Libor, while counterparty A, which provided EURs to counterparty B, received 3-month EUR Libor + a (alpha being the cross-currency basis swap spread). At the maturity of the contract, counterparty A and B both receive their regular intermediary cash flows, and also re-exchange their respective principal - but this time at the same spot rate as the one that existed at the entry of the contract (Chart 1, bottom panel). Chart 2A Bigger Funding Gap Equals##BR##A Wider Basis Swap Spread A Bigger Funding Gap Equals A Wider Basis Swap Spread A Bigger Funding Gap Equals A Wider Basis Swap Spread In both regular FX and cross-currency basis swaps, counterparties have removed their FX risks, except that in the latter, the interest differentials have been paid during the life of the contract instead of being factored through the forward premium/discount. This is fine and dandy, but it leaves a unexplained. The cross currency basis swap spread (a), is a direct function of the relative supply and demand for each currency. If investors demand a lot of EUR in the swap market relative to its supply, a will be positive. If they demand more USDs, a will be negative. A good example of this dynamic is the funding gap of banks. Let's take the Japanese example. Japanese banks have a surplus of domestic deposits (thanks to the massive savings of the Japanese corporate sector) relative to their yen lending. As a result, they have large dollar lending operations. To hedge their dollar assets, Japanese banks borrow USD in large quantities in the cross-currency swap market. This tends to result in a negative swap spread in the yen (Chart 2). This is particularly true if both the banking sector and the other actors in the economy (institutional investors and non-financial firms) also borrow dollars in the swap market to hedge dollar assets, which is the case in Japan (Chart 3). Chart 3Japanese Investors Are Accumulating Assets Abroad It's Not My Cross To Bear It's Not My Cross To Bear Additionally, if there are perceived solvency risks in the European banking sector, this should further weigh on the cross-currency basis swap spread, pushing it deeper into negative territory, as the viability of the main EUR counterparties becomes at risk. The same dance is true for any currency pair. The other factor that affects USD cross-currency basis swap spreads is the supply of U.S. dollars, especially the room on large banks' balance sheets to service these markets. The cross-currency basis swap spread could be close to zero if large arbitrageurs take offsetting positions to arbitrage the spread away, doing so until the spread disappears. However, with the imposition of Basel III and Dodd-Franks, banks have been constrained in their capacity to do this. Indeed, increased leverage ratio requirements (now banks need to post more capital behind repo transactions as well as collateralized lending and other derivatives) mean that arbitraging cross-currency basis swap spreads and deviations from covered interest rate parity has become much more expensive. Furthermore, the increase in Tier 1 capital ratios associated with these regulations has forced banks to de-lever; however, engaging in arbitrage activities still requires plenty of leverage (Chart 4). Chart 4The Structural Gap In The Basis Swap##BR##Spread Reflects Regulation The Structural Gap In The Basis Swap Spread Reflects Regulation The Structural Gap In The Basis Swap Spread Reflects Regulation Economic Factors Driving The Spread The factors that we look at essentially relate to the supply of USD available for lending in offshore markets, as well as determinants of relative counterparty risks between the U.S. and the rest of the world. Factors Arguing For Narrower Cross-Currency Basis Swap Spreads 1. Global Banks Health Chart 5Banks Perceived Health##BR##Determines Basis Swap Spreads Banks Perceived Health Determines Basis Swap Spreads Banks Perceived Health Determines Basis Swap Spreads The price-to-book ratio of global banks outside the U.S. has been largely correlated with USD cross-currency swap spreads. When global banks get de-rated, spreads widen, and it becomes more expensive to hedge USD positions in the swap market (Chart 5). This is because as investors perceive the solvency of global banks deteriorating, they impose a penalty as the Herstatt risk increases. Additionally, solvency problems can force banks to scramble to access USD funding, prompting deeper spreads. BCA is positive on global financials and sees continued improvement in European NPLs. This means that solvency risk concerns are likely to remain on the backburner for now, pointing to narrower basis swap spreads. 2. Supplementary Leverage Ratio Changes In June, the U.S. Treasury announced a relaxation of some of its rules on supplementary leverage ratios, lowering the amount of capital required to support activity in the repo market behind initial margins for centrally cleared derivatives, and behind holdings of Treasurys. This means that commercial banks in the U.S. can have bigger balance sheets and more room to engage in arbitrage activity, implying a greater supply of dollars in the USD cross-currency basis swap market. In response to last June's proposal, basis swap spreads narrowed by 11 basis points. BCA believes these changes will continue to support dollar liquidity, and will further help in narrowing cross-currency basis swap spreads. 3. Prime Money-Market Funds Debacle Is Over Chart 6More Expensive Bank Funding##BR##= Wider Basis Swap Spreads More Expensive Bank Funding = Wider Basis Swap Spreads More Expensive Bank Funding = Wider Basis Swap Spreads In October 2016, regulatory changes were implemented that allowed prime money market funds to have fluctuating net asset values. Obviously, this meant that prime money-market funds would be not-so-prime anymore. As a result, to remain the ultra-safe vehicles that they once were, prime money-market funds de-risked. As a result, they cut their exposure to risky activities in anticipation of these changes. In practice, a key source of short-term funding for banks evaporated from the market, putting upward pressure on bank financing costs. As the LIBOR-OIS spread increased, so did basis-swap spreads (Chart 6): as it became more expensive for banks to finance themselves, they had to curtail the supply of USDs provided to the swap market, an activity normally requiring intense demand on banks' balance sheets. This adjustment is now over, suggesting limited potential widening in USD basis swap spreads. Factors Arguing For Wider Cross-Currency Basis Swap Spreads 1. U.S. Loan Growth When U.S. banks increase their loan formation activity, USD cross-currency basis swap spreads widen (Chart 7). As banks increase their extension of credit through loans, they decrease the amount of securities they hold on their balance sheets (Chart 8). This means there is less supply of liquidity available for balance sheet activities, particularly providing dollar funding in the offshore market. In the Basel III / Dodd-Frank world, less-liquid bank balance sheets are synonymous with wider USD basis-swap spreads. As we argued last week, increasing U.S. capex, easing lending standards for firms and rising household income levels should result in increasing loan growth in the U.S. which will result in lower abundance of liquid assets and a widening basis swap spreads.1 Chart 7More Bank Loans Lead##BR##To Wider Swap Spreads More Bank Loans Lead To Wider Swap Spreads More Bank Loans Lead To Wider Swap Spreads Chart 8More Debt Equals Less##BR##Securities In Bank Credit More Debt Equals Less Securities In Bank Credit More Debt Equals Less Securities In Bank Credit 2. U.S. Inflation There is a fairly close relationship between U.S. inflation and the USD basis swap spread, where a higher core CPI tends to lead to a wider spread (Chart 9). The fall in U.S. inflation this year likely contributed to the narrowing in basis swap spreads. Our take on this is that as inflation falls, it gives an incentive for banks to hold low-yielding liquidity on their balance sheets as real returns on cash improve. This fuels a gigantic carry trade through the basis-swap market. We expect inflation to pick up meaningfully by mid-2018, which should widen cross-currency basis swap spreads.2 Chart 9When U.S. Inflation Increases, Swap Spreads Widen When U.S. Inflation Increases, Swap Spreads Widen When U.S. Inflation Increases, Swap Spreads Widen 3. Central Bank Balance Sheets When the Federal Reserve increases the size of its balance sheet relative to other balance sheets, this tends to lead to a narrowing of the USD basis swap spread as the global supply of dollars relative to other currencies increases. The opposite is also true. This relationship did not work after late 2016 (Chart 10). However, during that episode, as the change in prime money-market funds caused a dislocation in banks' funding, commercial banks exhibited cautious behavior and increased their reserves with the Fed. As Chart 11 illustrates, there is a tight relationship between the change in commercial banks' reserves held at the Fed and cross-currency basis swap spreads. Going forward, as the Fed lets it balance sheet run off, we expect to see a decrease in commercial banks' excess reserves. This could contribute to upward movement in the basis swap spread. Chart 10Smaller Fed Balance Sheet Leads##BR##To Wider Basis Swap Spreads Smaller Fed Balance Sheet Leads To Wider Basis Swap Spreads Smaller Fed Balance Sheet Leads To Wider Basis Swap Spreads Chart 11Fed Runoff Could Widen##BR##Basis Swap Spreads Fed Runoff Could Widen Basis Swap Spreads Fed Runoff Could Widen Basis Swap Spreads 4. U.S. Repatriations Chart 12U.s. Repatriations Support Wider##BR##Basis Swap Spreads U.s. Repatriations Support Wider Basis Swap Spreads U.s. Repatriations Support Wider Basis Swap Spreads The most revealing relationship unearthed in our study was that when U.S. entities repatriate funds at home, this tends to put strong widening pressure on the USD cross-currency basis swap spread (Chart 12). U.S. businesses hold large cash piles abroad - by some estimates more than US$2.5 trillion. However, most of these funds are held in highly liquid, high-quality U.S.-dollar assets offshore. These assets are perfect collaterals for various transactions in the interbank market. The funds held abroad by U.S. firms are a source of supply for U.S. dollars in the offshore markets. When U.S. entities bring assets back home, the widening in the basis swap spread essentially reflects a decline in the supply of USD in offshore markets, and vice versa when Americans export capital abroad. BCA's base case is that tax cuts are likely to hit the U.S. economy in 2018, even if the growing feud between Trump and the establishment Republican party members is a growing risk. BCA still views a tax repatriation as a higher-likelihood event, as it is the easiest way for the U.S. government to bring funds into its coffers. The 2004 tax repatriation under former President George W. Bush did result in substantial fund repatriation in the U.S. This time will not be different. We expect any such tax repatriation to cause a potentially large deficit of supply in the USD offshore markets, which could create a strong widening basis on the cross-currency basis swap spread in favor of the dollar. Bottom Line: Three factors argue for USD cross-currency basis swap spreads to stay at current levels, or even narrow further. These factors are the health of global banks, the easing in U.S. supplementary leverage ratios and the end of the adjustment of U.S. bank funding to new regulations affecting prime money-market funds. On the other hand four factors points to wider USD cross-currency basis swap spreads: BCA's positive outlook for U.S. credit growth; BCA's positive outlook on U.S. inflation; the run-off of the Fed's balance sheet; and the potential for U.S. entities repatriating funds from abroad. Potential Direction And Investment Implications We anticipate USD cross-currency basis swap spreads to widen over the coming 12 months. We think the easing in the Supplementary Leverage Ratios rules by the U.S. Treasury is the most important factor pointing to narrower USD cross-currency basis swap spreads. However, Basel III rules and most of Dodd-Frank are still in place, which suggest there remains large constraints on the balance-sheet activities of global banks, which will limit the potential for a narrowing of the USD basis swap spread as U.S. banks will remain constrained in their ability to supply U.S. dollars in the offshore market. Chart 13Wider Basis Swap Spreads Equals Higher Vol Wider Basis Swap Spreads Equals Higher Vol Wider Basis Swap Spreads Equals Higher Vol On the other hand many factors support wider USD cross-currency basis swap spreads, most important of which is the potential for more credit growth. This is in our view a very strong force as it requires banks to ration the use of their balance sheets, limiting their activity in the offshore market. Moreover, we do foresee a high probability of tax repatriation, which would put strong widening pressure on the swap spreads. In terms of implications, wider USD basis swap spreads tend to be associated with rising FX vols (Chart 13). As we highlighted in a Special Report last year, higher FX vols are poison for carry trades.3 As such, we think that widening swap spreads could spur a period of trouble for traditional carry currencies. This means EM and dollar-block currencies are likely to suffer in this environment. Additionally, in China, Xi Jinping is consolidating power and has taken control of the Politburo. This implies he now has more room to implement reforms. Removal of growth targets after 2020, removal of growth as a criterion for grading local officials, a focus on balanced growth, and a focus on combatting pollution all suggest that Chinese growth is unlikely to follow the same debt-fueled, capex-led model.4 This will weigh on Chinese imports of raw materials, and hurt export volumes and prices for many EM countries and commodities producers. This means these policies represent a headwind for many carry currencies. Moreover, historically, wider USD funding costs have been associated with a stronger dollar, as it makes it more expensive to hedge dollar assets. Thus, in an environment where U.S. interest rates are rising relative to the rest of the world - making U.S. assets attractive - wider basis swap spreads are an additional factor that could lift the dollar. Bottom Line: We anticipate the USD cross-currency basis swap spread to widen over the next 12 months. This will be associated with higher FX vols, which hurt carry trades, EM currencies and dollar-block currencies. Chinese reforms will reinforce these risks. Additionally, wider basis swap spreads will create support for the USD. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, titled "All About Credit", dated October 20, 2017, available at fes.bcaresearch.com. 2 Please see Foreign Exchange Strategy Weekly Report, titled "Conflicting Forces For The Dollar", dated September 8, 2017, and "Is The Dollar Expensive?", dated October 13, 2017, available at fes.bcaresearch.com. 3 Please see Foreign Exchange Strategy Special Report, titled "Carry Trades: More Than Pennies And Steamrollers", dated May 6, 2016, available at fes.bcaresearch.com. 4 Please see Geopolitical Strategy Weekly Report, titled "Xi Jinping: Chairman Of Everything", dated October 25, 2017 and Special Report, titled "How To Read Xi Jinping's Party Congress Speech", dated October 18, 2017, available at gps.bcaresearch.com. Appendix Implications For The Global Fixed Income Investor Chart A1FX Basis Swaps Boosting##BR##Hedged European Yields FX Basis Swaps Boosting Hedged European Yields FX Basis Swaps Boosting Hedged European Yields The outlook for cross-currency basis swap spreads has important implications for global fixed income investors. Chiefly, a wider (more negative) basis swap spread makes it more profitable for U.S. investors to lend U.S. dollars. For example, the top panel of Chart A1 shows that if a U.S.-based investor swaps dollars for euros on a 3-month horizon, and then invests those euros in 10-year German bunds, they will earn a hedged yield of 2.5% (annualized). This compares to a current yield of 2.3% on the 10-year U.S. Treasury note. If the basis swap spread were zero, then the U.S. investor would face a hedged German 10-year yield of only 2.1%. Conversely, a deeply negative basis swap spread works against non-U.S. investors looking to gain exposure to the U.S. bond market. If a Eurozone-based investor swaps euros for dollars on a 3-month horizon and then invests those dollars in 10-year U.S. Treasuries, he will earn a hedged yield of 0.1% (annualized). This compares to a current yield of 0.4% on 10-year German bunds. If the basis swap spread were zero, then the European investor would face a more enticing hedged U.S. 10-year yield of 0.6%. The middle three panels of Chart A1 show the 10-year yields in other Eurozone bond markets from the perspective of a U.S.-based investor who has hedged his currency risk on a 3-month horizon, as per the strategy explained above. The bottom panel of Chart A1 shows that the deviation of the EUR/USD basis swap spread from zero currently adds 42 basis points to the hedged yields faced by a U.S. investor. Charts A2, A3, A4 and A5 present the same analysis for other major bond markets, again from the perspective of a U.S. based investor.5 Chart A2FX Basis Swaps Boosting Hedged Gilt Yields FX Basis Swaps Boosting Hedged Gilt Yields FX Basis Swaps Boosting Hedged Gilt Yields Chart A3FX Basis Swaps Boosting Hedged JGB Yields FX Basis Swaps Boosting Hedged JGB Yields FX Basis Swaps Boosting Hedged JGB Yields Chart A4FX Basis Swaps Boosting##BR##Hedged Canadian Yields FX Basis Swaps Boosting Hedged Canadian Yields FX Basis Swaps Boosting Hedged Canadian Yields Chart A5FX Basis Swaps Are NOT Boosting##BR##Hedged Australian Yields FX Basis Swaps Are NOT Boosting Hedged Australian Yields FX Basis Swaps Are NOT Boosting Hedged Australian Yields The Impact Of Hedging Costs On Returns Of course, the basis swap spread is only one input to hedging costs. Once again, using the example of a U.S.-based investor looking for exposure in European bond markets, we calculate the hedging cost as: (1 + Hedging Cost) = (1 + 3-month EUR LIBOR + basis swap spread) / (1 + 3-month USD LIBOR) Right now the hedging cost in the above example is below zero. This is why German bund yields actually appear more attractive to U.S. investors after taking hedging costs into account. But what's more interesting is that total returns in 7-10 year German bunds (hedged into USD) relative to total returns in 7-10 year U.S. Treasury notes track hedging costs very closely over time (Chart A6). Chart A6Hedging Costs Will Continue To Boost Hedged German Bond Returns As The Fed Hikes Rates Hedging Costs Will Continue To Boost Hedged German Bond Returns As The Fed Hikes Rates Hedging Costs Will Continue To Boost Hedged German Bond Returns As The Fed Hikes Rates This is highly logical. As hedging costs become more negative, it means that U.S.-based investors make more money swapping U.S. dollars for euros. Therefore, a strategy of swapping dollars for euros, and then placing the proceeds in 7-10 year German bunds should continue to be a profitable one for U.S. investors as long as hedging costs continue to decline. Fortunately for U.S. investors, hedging costs should become even more negative during the next 12 months. In our base case scenario, we assume that the Federal Reserve will lift rates by 100bps by the end of 2018. We also assume that the ECB will not lift rates during this timeframe. That divergence in policy rates on its own will drive hedging costs further into negative territory, and it will only be exacerbated if the cross-currency basis swap spread widens as we anticipate. We illustrate the impact of the cross-currency basis swap spread on hedging costs in the bottom panel of Chart A6. The panel shows where hedging costs will go between now and the end of 2018, assuming policy rates move as we described above, and that the basis swap spread either widens to -100 bps or tightens back to zero. It is evident that a sharp widening in basis swap spreads would be a boon for U.S. investors in foreign bond markets. Bottom Line: Deeply negative basis swap spreads make it more profitable to lend dollars on a short-term horizon. This presents an opportunity for U.S. investors to swap dollars for foreign currencies and invest in non-U.S. bond markets. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 5 While the basis swap spread between the U.S. and most countries is negative, it is actually positive between the U.S. and Australia. So in this case the basis swap spread makes Australian bonds look less attractive to U.S. investors. Conversely, the basis swap spread makes U.S. bonds look slightly more attractive to Australian investors.

Highlights Jerome Powell takes the helm of the Federal Reserve at a time when both sides of the Fed's dual mandate are in conflict. The lagging nature of inflation explains why it has failed to rise even though the unemployment rate has fallen below NAIRU. U.S. growth should surprise on the upside over the coming quarters, with or without the passage of tax legislation. This should enable the Fed to raise rates four times by end-2018, which should give the dollar a boost. Higher oil prices will prop up the Canadian dollar. Brexit uncertainty will continue to weigh on the U.K. economy, but the pound has already priced in much of the bad news. Feature Chart 1The Dual Mandate Headache The Dual Mandate Headache The Dual Mandate Headache Jay Powell: You're Hired! Jerome Powell takes the helm of the Federal Reserve at a pivotal time. Under Janet Yellen's leadership, the Fed began running down its balance sheet. For all intents and purposes, that part of the normalization process has been put on autopilot. In contrast, the question of how much higher interest rates need to go remains up in the air. In normal times, the Fed would be guided by its dual mandate, which calls for maximum sustainable employment and low inflation. The Fed's predicament is that the two sides of this mandate are currently in conflict: While the unemployment rate has fallen more than the FOMC anticipated at the start of the year and is below the Fed's estimate of full employment, inflation has dipped further below the Fed's 2% target (Chart 1). Why Has Inflation Been So Low? There are four competing explanations for why inflation remains stubbornly low. The first is that the headline unemployment rate understates the true amount of labor market slack. There was considerable merit to this argument a few years ago, but it seems less plausible today. While some auxiliary measures of slack, such as involuntary part-time employment and the share of the working-age population that is out of the labor force but wants a job, are still elevated relative to pre-recession levels, others such as the job openings rate and household perceptions of job availability have reached levels consistent with an overheated economy (Table 1). Taken together, the U.S. labor market appears to be close to full employment. Table 1Comparing Current Labor Market Slack With Past Cycles Powell's Predicament Powell's Predicament The second explanation for why higher inflation has failed to materialize accepts the centrality of the unemployment rate as an accurate summary measure of labor market slack, but posits that NAIRU - the so-called Non-Accelerating Inflation Rate of Unemployment - is lower than widely believed. NAIRU cannot be observed directly, so in principal this argument could be true. That said, it is worth noting that official estimates of NAIRU are already well below their long-term average (Chart 2). While certain factors such as the aging of the workforce have reduced NAIRU - older people tend to change jobs less frequently, which reduces frictional unemployment - other factors have likely raised it. These include automation, globalization, and the opioid crisis, all of which have probably led to higher structural unemployment. The third explanation for why inflation has failed to rise in the face of falling unemployment is that the Phillips curve has broken down. Whether they realize it or not, people who make this argument are implicitly assuming that NAIRU no longer matters - that central banks can drive the unemployment rate down as far as they wish and not worry about runaway inflation. If true, this would seemingly revoke the law of supply and demand because it would imply that an economy can stay perpetually overheated without wages or prices ever having to rise. Alas, no such free lunch exists. Chart 3 shows that the relationship between wage growth and unemployment remains intact. The so-called "wage-Phillips curve" tends to steepen sharply once unemployment falls below 5%. The recent acceleration in average hourly wages, median weekly earnings, and the Employment Cost Index all suggest that we have reached the steep part of the Phillips curve (Chart 4). Chart 2NAIRU Estimates Are Historically Low NAIRU Estimates Are Historically Low NAIRU Estimates Are Historically Low Chart 3U.S. Economy Has Moved Into ##br##The 'Steep' Part Of The Phillips Curve Powell's Predicament Powell's Predicament Chart 4U.S. Wage Growth Is Accelerating U.S. Wage Growth Is Accelerating U.S. Wage Growth Is Accelerating Higher wage growth will push up real household disposable income, leading to more consumer spending. With the output gap now effectively closed, firms will find themselves running into more supply-side constraints, forcing them to raise prices. Just as in the past, "this time is different" explanations for why inflation will stay depressed, such as the overhyped "Amazon effect," will be proven wrong.1 This leads us to the fourth - and in our view, most cogent - explanation for why inflation has been low, which is that the Phillips curve has simply been dormant. History suggests that inflation is a highly lagging indicator (Chart 5). A variety of technical factors - ranging from a steep drop in cell phone data charges to a dip in prescription drug prices - have depressed inflation this year. As these wear off, inflation will slowly pick up. The recent increase in the ISM prices-paid component, along with producer price indices around the world, suggest that both domestic and external inflationary pressures are intensifying. Consistent with this, the NY Fed's "underlying inflation gauge" has reached an 11-year high of 2.8% (Chart 6). Chart 5Inflation Is A Lagging Indicator Powell's Predicament Powell's Predicament Chart 6Fed Sees Underlying Inflation Gathering Steam Fed Sees Underlying Inflation Gathering Steam Fed Sees Underlying Inflation Gathering Steam The Cost Of Waiting Admittedly, there is a lot of uncertainty about the degree to which inflation will accelerate over the next few years. With that in mind, many commentators have argued for a go-slow approach. "Wait to see the whites of inflation's eyes" as Larry Summers has colorfully stated. This perspective is not unreasonable, but we think most FOMC members will ultimately reject it. This is mainly because inflation is a highly lagging indicator. By the time it is obvious that inflation is getting out of hand, it is often too late to react. The unemployment rate is already half a percentage point below the Fed's estimate of NAIRU. If the labor market continues to firm up, the Fed will eventually have no choice but to tighten monetary policy by enough to bring the unemployment rate back up to NAIRU. This means that rates may have to rise above their neutral level for a considerable period of time. Such an outcome could lead to a significant re-rating of risk asset prices. It would also damage the economy. The U.S. has never avoided a recession in the post-war period whenever the three-month average level of the unemployment rate has risen by more than 0.3 percentage points (Chart 7). Chart 7What Goes Down Must Come Up? What Goes Down Must Come Up? What Goes Down Must Come Up? Already Behind The Curve The Fed has arguably already fallen behind the curve in normalizing monetary policy. As our models predicted, the easing in U.S. financial conditions earlier this year is helping to turbocharge growth (Chart 8). Real GDP rose by 3.0% in the third quarter. Growth would have been even higher had residential investment not fallen by 6% in the wake of the hurricanes. The Atlanta Fed's GDPNow model is pointing to growth of 4.5% in Q4. Chart 8U.S.: Easier Financial Conditions Are Boosting Growth U.S.: Easier Financial Conditions Are Boosting Growth U.S.: Easier Financial Conditions Are Boosting Growth Core capital goods orders are increasing at a solid pace. The Conference Board's index of consumer confidence rose to a 17-year high in October. Initial jobless claims have fallen to a four-decade low. Citi's economic surprise index has spiked into positive territory and Goldman's is nearing record highs (Chart 9). Given the recent acceleration in growth, the unemployment rate is likely to fall to 3.5% by the end of next year - well below the Fed's current end-2018 projection of 4.1%. If Congress delivers on its pledge to reduce corporate and personal income taxes, this would represent a further modest upward surprise to near-term growth prospects. Fiscal policy remains a wildcard. The "Tax Cut and Jobs Act" released by the House of Representatives yesterday seeks to reduce taxes by about $1.5 trillion over the next ten years, with two-thirds of that amount consisting of lower business taxes (Table 2). Negotiations with the Senate are likely to result in a scaling back of the magnitude of the cuts and a shifting of more of the benefits towards middle-class earners. Among other things, this probably means the proposed phase-out of the estate tax will be scrapped. Most empirical estimates suggest that the growth benefits from the legislation will be modest. Nevertheless, if taxes are cut early next year, as we think is likely, this will put a greater impetus for the Fed to raise rates. Chart 9U.S. Economy Surprising On The Upside U.S. Economy Surprising On The Upside U.S. Economy Surprising On The Upside Table 2U.S.: How Much Will The Tax Plan Cost? Powell's Predicament Powell's Predicament Aging Bull Stocks are likely to weather the impact of Fed hikes as long as rates are rising in an environment of stronger GDP growth. Chart 10 shows that equities tend to do well when the ISM manufacturing index is elevated. This leads us to think the cyclical bull market in stocks will continue for the next 12 months. Chart 10Stocks Fare Well When The ISM Is Strong Stocks Fare Well When The ISM Is Strong Stocks Fare Well When The ISM Is Strong Once inflation begins to rise in earnest in 2019, equities will buckle. Given that the United States accounts for over half of global stock market capitalization, a selloff in the U.S. will be quickly transmitted to the rest of the world. Short-term oriented investors should remain overweight global equities for now, but look to turn more defensive late next year. Long-term investors should consider paring back exposure already. U.S. Dollar: Stronger For Now, Weaker in 2019 Once the U.S. falls into a recession in late 2019 and the Fed starts cutting rates, the dollar will crumble. But until then, the odds are that the greenback strengthens. Our model suggests that the dollar is undervalued against the euro based on today's level of spreads (Chart 11). Hence, even if spreads remain unchanged, we would expect the dollar to strengthen somewhat. Keep in mind that 10-year German bunds yield nearly two percentage points less than U.S. Treasurys. The euro would have to strengthen to 1.42 against the dollar over the next ten years just to compensate for the lower interest rates that bunds offer. Granted, if spreads between Treasurys and bunds were to narrow significantly, the euro would appreciate. Such an outcome is probable in 2019, by which time investors will begin fretting about a looming U.S. recession and pricing in Fed rate cuts. However, it is not likely to occur over the next 12 months, given the prospect that U.S. growth will accelerate over this period. Chart 12 shows the market's expectation of where one-month OIS rates will be in the U.S. and euro area over the next ten years. The one-month transatlantic rate spread currently stands at 151 basis points and is expected to peak in February 2019 at 210 basis points. It then declines gradually, falling to 164 basis points in five years and 107 basis points in ten years. Chart 11Dollar Is Undervalued Based On Current Spreads Dollar Is Undervalued Based On Current Spreads Dollar Is Undervalued Based On Current Spreads Chart 12Rates Will Diverge More In 2018 Than Is Priced In Rates Will Diverge More In 2018 Than Is Priced In Rates Will Diverge More In 2018 Than Is Priced In Relative to current market expectations, the interest rate spread one-year out is likely to widen further over the coming months. The market is currently pricing in 54 basis points of Fed rate hikes between now and end-2018, well below the "dot" forecast of 100 basis points. For his part, Mario Draghi made it clear last week that the ECB's bond buying program will continue until September 2018, and that the central bank will not raise rates until "well past the horizon of our asset purchases." Chart 13The Euro Has Overshot Interest Rate Spreads The Euro Has Overshot Interest Rate Spreads The Euro Has Overshot Interest Rate Spreads There is less scope for spreads to widen if one looks at expected interest rates more than one year into the future. However, we don't see much room for spread compression in the near term, so long as U.S. growth continues to surprise on the upside. Long-term inflation expectations are about 55 basis points lower in the euro area than they are in the U.S. As such, the expected spread in real short-term rates ten years out stands at about 50 basis points (Chart 13). This is not much different from Laubach and Williams' estimate of the gap in the real neutral rate between the U.S. and the euro area. Moreover, as we noted two weeks ago, the actual gap in expected interest rates should be larger than what is implied by neutral rate estimates since unemployment is likely to be above NAIRU more often in the euro area than in the United States.2 On balance, we remain comfortable with our year-end target for EUR/USD of 1.15 and see further upside for the dollar against the euro in 2018. Bank Of Japan: Nowhere Near The Exit Door The yen should also continue to trade down against the greenback. Governor Kuroda dismissed speculation that the BoJ is considering dialing back monetary accommodation during his press conference following this week's Monetary Policy Meeting. The BoJ lowered its inflation outlook for both FY2017 and FY2018, but maintained its projection of reaching its 2% inflation target in FY2019. In perhaps a sign of the times, newly selected board member Goushi Kataoka cast a dissenting vote, arguing that monetary policy should be even more accommodative. Kataoka suggested that the BoJ consider extending its yield curve targeting regime to government bonds with maturities of up to 15 years. Currently, the government seeks to cap yields for maturities of up to ten years. As bond yields elsewhere in the world drift higher, JGBs will become increasingly unattractive. This will weigh on the yen. CAD: Fade The Recent Weakness The Canadian dollar has been on the back foot lately. Last week Governor Poloz mentioned that "a lot of things have to come together" for the Bank of Canada to raise rates in December. This week brought news that the economy shrank by 0.1% in August due to a decline in manufacturing output. The market has gone from fully pricing in a hike in December to only assigning a one-in-five chance that rates will rise. Worries that the Trump administration will pull out of NAFTA have also weighed on rate expectations. Still, one should keep things in perspective. Real GDP is up 3.5% year-over-year - well in excess of the BoC's estimate of trend growth - while the output gap has been fully closed. Canadian GDP growth has historically been closely correlated with U.S. growth, so it would be very surprising if Canada's economy were to flounder just as America's is gaining steam (Chart 14). Chart 14Canada Remains Linked To The U.S. Canadian And U.S. Growth Are Correlated Canada Remains Linked To The U.S. Canadian And U.S. Growth Are Correlated Canada Remains Linked To The U.S. Canadian And U.S. Growth Are Correlated Chart 15The Pound Is Cheap Powell's Predicament Powell's Predicament And while the risk of a NAFTA pullout is real, most of Trump's wrath has been focused on Mexico. If NAFTA were to fall apart, Canada would still be covered by preexisting Canada-U.S. trade agreements. We will discuss this and other trade-related issues in a Special Report to be published next week. Perhaps most critically for the loonie, crude prices remain in an uptrend. BCA's energy strategists now see Brent averaging $65.2/bbl and WTI averaging $62.9/bbl in 2018, which is $6.2/bbl and $8.9/bbl, respectively, above current market expectations. Stick with it. Bank Of England Delivers A Dovish Hike In a split 7-to-2 decision, the Bank of England's Monetary Policy Committee voted to raise rates by 25 basis points for the first time in ten years yesterday. In a nod to the concerns that some board members had about raising rates, the MPC noted that "any future increases in the Bank Rate would be expected to be at a gradual pace and to a limited extent." The Committee also removed language suggesting that future rate hikes would have to be in excess of what the market has been pricing in. The MPC's reluctance to sound hawkish is understandable. While the unemployment rate has fallen to a four-decade low, growth has lagged behind the rest of Europe. Consumer confidence has weakened and the CBI retailers survey suggests that British households are tightening their purse strings. House prices in London have fallen 7% since the U.K. government started the formal process of Brexit seven months ago. Inflation is running at 3%, but this mainly reflects the lagged effects from the depreciation in the currency. Still, with the market pricing in only two additional hikes through to mid-2020, it is doubtful that rate expectations will fall much from current levels. There is also a reasonably high probability that Brexit will not occur. At some point over the next few years, the U.K. government will call a new referendum to affirm whatever deal it reaches with the EU. Given that the contours of the deal will be less favorable than what many pro-Brexit voters had been promised, it is likely that a majority of the populace will decide that life inside the EU is better after all. As such, the odds are good that the pound - which is very cheap based on our valuation measures - will strengthen over the long haul (Chart 15). Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see The Bank Credit Analyst Special Report, "Did Amazon Kill The Phillips Curve?" dated September 1, 2017 and Global Investment Strategy Weekly Report, "Is The Phillips Curve Dead Or Dormant?" dated September 22, 2017. 2 Please see Global Investment Strategy Weekly Report, "China, The Fed, And The Transatlantic Interest Rate Spread," dated October 20, 2017. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights The three deflationary anchors of the global economy have abated: The U.S. private sector deleveraging is over, the euro area economy is escaping its post crisis hangover, and the destruction of excess capacity in China is advanced. This means that global central banks are in a better position than at any point this cycle to normalize policy, pointing to higher real rates. As a result, gold prices will suffer significant downside. The populist wave in New Zealand is based on inequalities and is here to stay. This will hurt the long-term outlook for the Kiwi. However, short-term NZD has upside, especially against the AUD. The BoE hiked rates, but upside surprises to policy is unlikely now. The pound remains at risk from Brexit negotiations. Feature Chart I-1Gold Is Setting Up For A Big Move Gold Is Setting Up For A Big Move Gold Is Setting Up For A Big Move Gold is at an interesting juncture. Gold prices, once adjusted for the trend in the U.S. dollar, have been forming a giant tapering wedge since 2011 (Chart I-1). This type of chart formation does not necessarily get resolved by an up-move, nor does it indicate a clear bearish pattern either. Instead, it points toward a potential big move in either direction. For investors, the key to assess whether this wedge will be resolved with a rally or a rout is the trend in global monetary conditions and real rates. In our view, the global economic improvement witnessed in 2017 suggests the world needs less accommodation than at any point since the onset of the great financial crisis. Thus, global accommodation will continue to recede, global real rates will rise and gold will suffer. The Exit Of The Great Deflationary Forces Since the financial crisis, in order to generate any modicum of growth, global monetary authorities have been forced to maintain an incredible degree of monetary accommodation in the global financial system. Central banks' balance sheets have expanded massively, with the Federal Reserve, the European Central Bank, the Bank of Japan, the Bank of England and the Swiss National Bank all increasing their asset holdings by 16% of GDP, 26% of GDP, 70% of GDP, 17% of GDP and 97% of GDP respectively. Real rates too have been left at unfathomable levels, with average real policy rates in the U.S., the euro area, Japan and the U.K. standing at 0.13%, -1.15%, -0.19%, and -2.12%, respectively. Despite all this easing, core inflation in the OECD has only averaged 1.68% since 2010, and real growth 2.05% - well below the averages of 2.3% and 2.44%, respectively, from 2001 to 2007. Explaining this extraordinary situation have been three key anchors that have conspired to create strong deflationary forces that have necessitated all this stimulus: the first was U.S. private sector deleveraging, with at its epicenter the rebuilding of household balance sheets. The second was the euro area crisis, which also caused a forced deleveraging in the Spanish and Irish private sector as well as in the Greek and Portuguese public sectors. The third was China's purging of excess capacity in the steel and coal sectors, as well as various heavy industries. These three deflationary anchors seem to have finally passed. In the U.S., nonfinancial private credit is slowly showing signs of recovering. Households have curtailed their savings rate, suggesting a lower level of risk aversion. Even more importantly, the growth in savings deposits is sharply decelerating, which historically tends to be associated with a re-leveraging of the household sector and increasing consumption (Chart I-2). Strong new home sales point toward these developments. The corporate sector is also displaying an important change in behavior. Share buybacks are declining, and both capex intentions and actual capex are recovering smartly - powered by strong profit growth (Chart I-3). This is crucial as it suggests firms are not recycling the liquidity they generate through their operations or their borrowings in the financial markets. Thus, with banks easing their lending standards, additional debt accumulation by firms is likely to support aggregate demand, eliminating a key deflationary force in the global economy. Chart I-2Household Deleveraging Is Over Household Deleveraging Is Over Household Deleveraging Is Over Chart I-3Companies Are Borrowing To Invest Companies Are Borrowing To Invest Companies Are Borrowing To Invest Moreover, Jay Powell's nomination to helm the Fed is also important. He is a proponent of decreasing bank regulation, especially for small banks that greatly rely on loan formation for their earnings. A softening in regulatory stance on these institutions could contribute to higher credit growth in the U.S. With aggregate liquidity conditions of the private sector - shown by the ratio of liquid assets to liabilities - having already improved, and indicating that a turning point in U.S. inflation will soon be reached, more credit growth could further stoke inflation (Chart I-4). Europe as well is also escaping its own morose state. ECB President Mario Draghi's fateful words in July 2012 resulted in a compression of peripheral spreads as investors priced away the risk of a breakup of the euro area (Chart I-5). As a result, the massive policy easing associated with negative rates and the ECB's expanded asset purchase program was transmitted to the parts of the euro area that really needed that easing: the periphery. Now, Europe is booming: Monetary aggregates have regained traction, real GDP growth is growing at a 2.3% annual pace, PMIs are growing vigorously, and even the unemployment rate has fallen back below 9%. European inflation remains low, but nonetheless the nadir of -0.6% hit in 2015 has also passed (Chart I-6). Chart I-4Liquid Private Balance Sheet Point To Inflation Liquid Private Balance Sheet Point To Inflation Liquid Private Balance Sheet Point To Inflation Chart I-5Draghi Held The Key To Help Europe Draghi Held The Key To Help Europe Draghi Held The Key To Help Europe Chart I-6Europe Past The Worst Europe Past The Worst Europe Past The Worst In China too we have seen important progress. Curtailment to excess capacity in the steel and coal sectors as well as across a wide swath of industries are bearing fruit (Chart I-7). China is not the source of deflation that it was as recently as 2015. Industrial profits have stopped contracting, industrial price deflation is over, and even core consumer prices are showing signs of vigor, growing at a 2.28% pace, the highest since the 2010 to 2011 period (Chart I-8). Thanks to these developments, global export prices have stopped deflating and are now growing at a 4.64% annual pace. With the three deflationary anchors having been slain, global growth is now able to escape its lethargy, with industrial activity at its strongest since 2003, while global capacity utilization has improved (Chart I-9). This is giving global central banks room to remove their easing. The Fed has already hiked rates four times and is embarking on decreasing its balance sheet; the Bank of Canada has followed suit two times, and the BoE, one time. Even the ECB is now beginning to taper its own asset purchases. We do anticipate this trend to continue with more and more central banks, with potentially the exception of the BoJ, joining the fray as the global environment remains clement. Even the People's Bank of China is likely to keep tightening policy due to the increasingly inflationary environment being experienced. Chart I-7Chinese Excess Capacity Purge Chinese Excess Capacity Purge Chinese Excess Capacity Purge Chart I-8China Doesn't Export Deflation Anymore China Doesn't Export Deflation Anymore China Doesn't Export Deflation Anymore Chart I-9Central Banks Can Normalize Central Banks Can Normalize Central Banks Can Normalize Bottom Line: The three anchors of global deflation have been slain. Private sector deleveraging in the U.S. is over, the euro area has healed and Chinese excess capacity has declined. As a result, global economic activity is at its strongest level in 14 years, and deflationary forces are becoming more muted. This is giving global central banks an opportunity to normalize policy without yet killing the business cycle. Implications For Gold Gold is likely to fare very poorly in this environment. Gold can be thought of as a zero coupon, extremely long-maturity inflation-indexed bond. This means that gold is a function of both inflation and real rates. Currently, gold offers little protection against outright inflation, having moved out of line with prices by a very large margin (Chart I-10). This leaves gold extremely vulnerable to development in real rates and liquidity. Saying that central banks can begin to normalize policy is akin to saying that central banks are in a position where letting real rate rise is feasible. As Chart I-11 illustrates, there has been a strong negative relationship between TIPS yields and gold prices. Moreover, when one looks beyond the price of gold in U.S. dollars, one can see that gold has been negatively affected by higher bond yields (Chart I-11, bottom panel). BCA currently recommends an underweight stance on duration, one that is synonymous with lower gold prices.1 Chart I-10Gold Is Expensive Gold Is Expensive Gold Is Expensive Chart I-11Higher Interest Rates Equal Lower Gold Higher Interest Rates Equal Lower Gold Higher Interest Rates Equal Lower Gold Moreover, the Fed's own research suggests that its asset purchases have curtailed the term premium by 85 basis points. The balance sheet run-off that the U.S. central bank is engineering will weaken that impact to a more meager 60 basis points by 2024. This also points to lower gold prices, as gold prices have displayed a negative relationship with the term premium (Chart I-12). An outperformance of financials in general but banks in particular is also associated with poor returns for gold (Chart I-13). Strong financials are associated with growing loan volumes, which mean a lesser need for policy easing, which puts upward pressure on the cost of money. Anastasios Avgeriou, who heads BCA's sectoral research, has an overweight on banks both globally and in the U.S. on the basis of the stronger loan growth we are beginning to see around the world.2 This represents a dangerous environment for gold. Chart I-12Normalizing Term Premium ##br##Is Dangerous For Gold Normalizing Term Premium Is Dangerous For Gold Normalizing Term Premium Is Dangerous For Gold Chart I-13Bullish Banks Equals ##br##Bearish Gold Bullish Banks Equals Bearish Gold Bullish Banks Equals Bearish Gold Finally, there is an interesting relationship between real stock prices and real gold prices. When stocks are in a secular bull market, gold prices are typically in a secular bear market (Chart I-14). A secular bull market in stocks tends to happen in an environment where there is more confidence that growth is becoming more durable, where there is less fear that currencies will have to be debased to support economic activity, or where inflation is not a destructive force like it was in the 1970s. These are environments where real rates tend to have upside. The continued strength in global equity prices, which are again in a secular bull market, would thus contribute to an increase in currently still-depressed global real yields, and thus, create downside in gold. One key risk to our view is that the Fed falls meaningfully behind the curve and lets inflation rise violently, which would put downward pressure on real rates and cause a violent correction in global equity prices - prompting investors to price in an easing in monetary policy. Geopolitics are another key risk, particularly a ratcheting up in North Korea tensions. With our bullish stance on the dollar, we are inclined to short the yellow metal versus the greenback. Moreover, for the past eight years, when net speculative positions in gold have been as elevated as they are today relative to net wagers on the DXY, gold in U.S. dollar terms has tended to weaken (Chart I-15). However, the analysis above suggests that gold could weaken against G10 currencies in aggregate. Thus investors with a more negative dollar view than ours could elect to sell gold against the euro. Agnostic players should short gold equally against the USD and the EUR. Chart I-14Gold And Stocks Don't Like Each Other Gold And Stocks Don't Like Each Other Gold And Stocks Don't Like Each Other Chart I-15Tactical Risk To Gold Tactical Risk To Gold Tactical Risk To Gold Bottom Line: The outlook for gold is negative. As the global economy escapes its deflationary funk and global central banks begin abandoning emergency easing measures, real interest rates will rise and term premia will normalize, which will put downward pressure on gold prices. Additionally, BCA's positive stance on banks is corollary with a negative outlook on gold. The continued bull market in stocks is an additional hurdle for gold. New Zealand: A New Hot Spot Of Populism The formation of the Labour/NZ First/Green coalition has sent ripples through the kiwi. The reaction of investors is fully rational, as the Adern government is carrying a very populist torch, sporting a program of limiting foreign investments in housing, limiting immigration, increasing the minimum wage and creating a dual mandate for the Reserve Bank of New Zealand. The key question is whether this is a fad, or whether something more profound is at play in New Zealand. We worry it is the latter. New Zealand has suffered from a profound increase in inequality since pro-market reforms were implemented in the 1980s. New Zealand's gini coefficient is very elevated, but even more worrisome has been the deteriorating trend. As Chart I-16 illustrates, the ratio of income of the top 20% of households relative to the bottom 20% has been in a steady uptrend. Additionally, this trend is sharper once the cost of housing is incorporated into the equation. Moreover, as Chart I-17 shows, New Zealand has experienced one of the most pronounced increases in housing costs among the G10. Chart I-16Growing Inequalities In New Zealand Reverse Alchemy: How To Transform Gold Into Lead Reverse Alchemy: How To Transform Gold Into Lead Chart I-17Kiwi Housing Is Expensive Reverse Alchemy: How To Transform Gold Into Lead Reverse Alchemy: How To Transform Gold Into Lead It is undeniable that the impact of immigration has been real. Net migration has averaged 24 thousand a year since 2000, on a population of 4.8 million. Moreover, the labor participation rate of immigrants has been higher than that of the general population, reinforcing the perception that immigration has contributed to keeping wage growth low (Chart I-18). The effect of low wage growth - whether caused or not caused by the increase in the foreign-born population - has been to boost household credit demand, pushing the national savings rate into negative territory, something that was required if households were to keep spending. These developments suggest that kiwi populism is not a fad, and is in fact a factor that will remain present in New Zealand politics. It also implies that policies designed to limit foreign investments into housing as well as immigration are indeed popular and will be implemented. What are the economic implications of these developments? Immigration was a key source of growth for New Zealand. As Chart I-19 shows, the growth of the kiwi economy since 1985 has been driven by an increase in the labor force. In fact, over the past five years, 86% of growth has been caused by labor force growth, with a very limited contribution from productivity gains. More concerning, as Chart I-20 shows, 44% of the increase in the population growth since 2012 has been related to immigration. Chart I-18The Narrative: Foreigners Steal Our Jobs The Narrative: Foreigners Steal Our Jobs The Narrative: Foreigners Steal Our Jobs Chart I-19Kiwi Growth: Labor Force Is Key Kiwi Growth: Labor Force Is Key Kiwi Growth: Labor Force Is Key Chart I-20Labor Force Growth Could Halve Reverse Alchemy: How To Transform Gold Into Lead Reverse Alchemy: How To Transform Gold Into Lead Additionally, according to the IMF's Article IV consultation for New Zealand, immigration has boosted output significantly, contributing to total hours worked as well as forcing an increase in the capital stock, which has boosted capex (Table I-1). Hence, lower intakes of foreign-born workers is likely to push down the country's potential growth rate. Limiting immigration in New Zealand could therefore have a significantly negative impact on the country’s neutral rate. As Chart 21 demonstrates, the real neutral rate for New Zealand, as estimated using a Hodrick-Prescott filter, is around 2%. A falling potential growth rate would push down the equilibrium policy rate in New Zealand, limiting how high the RBNZ's terminal policy rate will rise in the future. This points toward downward pressure on the NZD on a long-term basis. Shorting NZD/CAD structurally makes sense at current levels, especially as Canada remains open to immigration and immune to populism, as income inequalities are much more controlled there (Chart I-22). Table I-1Impact Of Immigration On Growth Reverse Alchemy: How To Transform Gold Into Lead Reverse Alchemy: How To Transform Gold Into Lead Chart I-21Kiwi Neutral Rate Has Downside Kiwi Neutral Rate Has Downside Kiwi Neutral Rate Has Downside Chart I-22NZD/CAD: Long-Term Heavy NZD/CAD: Long-Term Heavy NZD/CAD: Long-Term Heavy Limiting immigration in New Zealand could therefore have a significantly negative impact on the country's neutral rate. As Chart I-21 demonstrates, the real neutral rate for New Zealand, as estimated using a Hodrick-Prescott filter, is around 2%. A falling potential Shorter-term, the picture is slightly brighter for the NZD. Credit growth is strong, and is pointing toward an increase in the cash rate next year. Additionally, consumer confidence is high, and the labor market is showing signs of tightness, especially as the output gap stands at 0.87% of GDP (Chart I-23). This tightness in the labor market could easily be catalyzed into higher wage growth, especially as the new government is tabulating a 4.76% increase in the minimum wage in the coming quarters. Thus, BCA continues to expect an uptick in kiwi inflation and higher kiwi rates, even if a dual mandate for the RBNZ is implemented. Our favored way to play this strength in the kiwi remains going short the AUD/NZD. Our valuation model points to a strong sell signal in this cross (Chart I-24). Moreover, speculators are very long the AUD relative to the NZD, which historically has provided a contrarian signal to short it. Additionally, the concentration of power around Chinese President Xi Jinping points towards more reform implementations in China - reforms that we estimate will be targeted at decreasing the reliance of growth on debt-fueled investment while increasing the welfare of households, which should help Chinese consumption. As a result, metals could suffer relative to consumer goods. With New Zealand being a big exporter of foodstuffs and dairy products, this should represent a positive terms-of-trade shock for the kiwi relative to the Aussie. Chart I-23Short-Term Positives In New Zealand Short-Term Positives In New Zealand Short-Term Positives In New Zealand Chart I-24Downside Risk To AUD/NZD Downside Risk To AUD/NZD Downside Risk To AUD/NZD Bottom Line: The increase in populism in New Zealand is being fueled by a sharp increase in inequalities and rising housing costs. Immigration, rightly or wrongly, has been blamed in the public narrative for these ills. The measures announced by the Adern government target these issues head on, and we expect they will be implemented. This hurts New Zealand's long-term growth profile, and thus the terminal rate hit by the RBNZ this cycle. This could hurt the NZD on a structural basis. Tactically, it still makes sense to be short AUD/NZD. A Word On The BoE The BoE increased rates this week for the first time in a decade, but now acknowledges that current SONIA pricing is correct, removing its mention that risks are skewed toward higher rates than anticipated by the market. The pound sold off sharply on the news. Consumer confidence and retailer orders point to further slowdown in consumption. Thus, we think the British OIS curve is currently well priced, limiting any potential rebound in the GBP. Brexit continues to spook markets, rightfully. The political theater is far from over, and the continued uncertainty is likely to weigh further on the U.K. economy. This is likely to generate additional downside risk in the pound over the coming months. Thus, on balance, our current assessment is that the risks are too high to make a bullish bet on the GBP for now. A progress in the negotiations between the U.K. and the EU is needed before investors can buy the GBP, a currency that is cheap on a long-term basis. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Haaris Aziz, Research Assistant haarisa@bcaresearch.com 1 Please see Global Fixed Income Strategy Weekly Report, titled "Follow The Fed, Ignore The Bank Of England" dated September 19, 2017, available at gfis.bcaresearch.com 2 Please see Global Alpha Sector Strategy Weekly Report, titled "Buy The Breakout" dated May 5, 2017, available at gss.bcaresearch.com and U.S. Equity Strategy Weekly Report, titled "Girding For A Breakout?" dated May 1, 2017, available at uses.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 U.S. data was mixed: Core PCE was unchanged at 1.3%, and in line with expectations; Headline PCE was also unchanged at 1.6%; ISM Prices Paid came in at 68.5, beating expectations of 68; ISM Manufacturing came in weaker than expected. In other news, Jerome Powell is President Trump's pick as the next Fed chairman to replace Janet Yellen. Market reaction was muted as Powell is expected to continue in Yellen's footsteps and hike rates at a similar pace. While the Fed decided to leave rates unchanged this month, the probability of a December rate hike went up to 98%. We expect the USD bull market to strengthen next year when inflation re-emerges. Report Links: It's Not My Cross To Bear - October 27, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 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 was mixed: German and Italian inflation underperformed expectations and weakened compared to last month, while French inflation beat expectations; Overall European headline and core inflation also mixed expectations, coming in at 1.4% and 1.1% respectively; European preliminary GDP, however, beat expectations of 2.4%, coming in at 2.5%; The unemployment rate dropped to 8.9% for the euro area; The euro was up on Thursday after the nomination of Jerome Powell as Fed chair. His nomination represents a continuity of monetary policy. Despite this, we believe the re-emergence of inflation will cause the Fed to continue hiking after the December hike, deepening downward pressure on the euro next year. Report Links: Market Update - October 27, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 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 Japanese data has been mixed: Housing starts yearly growth came above expectations, coming in at -2.9%. However, housing starts did accelerate their contraction from August, when they were falling by 2% year-on-year. Industrial Production yearly growth came in above expectations, at 2.5%. However the jobs-to-applicants ratio came below expectations, staying put at 1.52. On Tuesday the BoJ left rates unchanged. Additionally the committee vowed to keep 10-year government bond yield around 0% and to continue their ETF purchases. More importantly, however, was the Bank of Japan's change to its outlook for inflation, which was decreased for this year. We continue to believe that deflation is too entrenched in Japan for the BoJ to change its policy stand. Thus, we expect USD/JPY to keep grinding higher, as U.S. monetary policy becomes more hawkish vis-à-vis Japan. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 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 surprised to the upside: Mortgage Approvals also outperformed expectations, coming in at 66.232 thousand. Moreover Nationwide house price yearly growth also outperformed, coming at 2.5% Both Markit Manufacturing PMI and Construction PMI outperformed, coming in at 56.3 and 50.8 respectively. The BoE hiked rates yesterday by 25 basis points as expected. Moreover, the committee also voted unanimously to maintain the stock of UK government bond purchases. However, the committee also acknowledged that inflation was not be the only effect of Brexit on the economy. They highlighted that uncertainty about the exit from the European Union was hurting activity despite a positive global growth backdrop. Overall, we think that the BoE will not deviate from the interest rate path priced into the OIS curve. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 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 Australian data was mixed: HIA New Home Sales contracted by 6.1%; AiG Performance of Manufacturing Index came in at 51.1, less than the previous 54.2; Exports increased by 3%, while imports stayed flat at 0%; The trade balance increased to AUD 1.745 bn, compared to the expected AUD 1.2 bn, and above the previous AUD 873 mn. The AUD was up on the release of the trade balance. But underlying slack in the economy, which worries RBA officials, points to a low fair value for the AUD. The AUD will be the poorest performer out of the commodity currencies, due to the relative strength of those economies and of oil relative to metals. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 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 positive: The unemployment rate came below expectations at 4.6%, it also decreased from last quarter's 4.8% reading. The participation rate came above expectations, at 71.1%. It also increased from 70% on the previous quarter. The Labour cost Index came in line with expectations at 1.9% yearly growth. However it increased from 1.6% in the previous quarter. Overall the New Zealand economy looks very strong. This should warrant a hike by the RBNZ. However the new government create a new set of long-term risks. The elected government is a response to the high inequality and high migration that the country had experienced in the recent years. Overall the plans to reduce immigration and install a double mandate to the RBNZ are bearish for the NZD, as the neutral rate of New Zealand would be structurally lowered. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 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 Canadian data has been weak recently: The raw material price index contracted by 0.1%; Industrial product prices contracted at a 0.3% monthly rate; GDP also contracted at a 0.1% monthly pace; Manufacturing PMI came out at 54.3, lower than the previous 55. In addition to this, Poloz identified several issues with the Canadian economy in his speech on Tuesday. These included the deflationary effects of e-commerce, slack in the labor market, subdued wage growth, and the elevated level of household debt. The probability of a rate hike has fallen to 22% for December, and it only rises above 50% in March next year. The CAD has lost a lot of its value since the BoC began hiking, but we believe it will resume hiking next year. Increasing oil prices will also mean that that CAD will outperform other G10 currencies. Report Links: Market Update - October 27, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 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 SVME Purchasing Manager's Index came above expectations at 62 in October. It also increased from the September reading. The KOF leading indicator also outperformed expectations significantly, coming at 109.1. EUR/CHF continues to climb unabated and is now only 3% from where it was before the SNB let the franc appreciate in January of 2015. Overall we see little indication that the SNB would let the franc appreciate again in the near future. On Wednesday, SNB Vice President Zurbruegg continued to talk down the franc by stating that a stronger CHF would cause a growth slowdown and that the CHF is still highly valued. Thus we expect downside in EUR/CHF to be limited for the time being. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 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: Retail sales growth underperformed expectations, as they contracted by 0.8% in September. However Norway's credit indicator surprised to the upside, coming in at 5.8%. Since September USD/NOK has appreciated by nearly 6%. This has been in an environment where oil has rallied by nearly 20%. Although this divergence might seem counterintuitive, it confirms our previous findings: USD/NOK is much more sensitive to real rate differentials than to oil prices. Inflationary pressures are still very tepid in Norway, while inflation is set to go higher in the U.S. These factors will further amplify the monetary policy divergences between these 2 countries, and consequently propel USD/NOK higher. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 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 Swedish Manufacturing PMI decreased to 59.3 from 63.7, below the expected 62. EUR/SEK has appreciated to June levels, implying that markets have priced out any potential hawkishness by the Riksbank. Similarly, USD/SEK has risen by 6.2% from September lows. This is due to the re-chairing of Stefan Ingves, known for negative rates and quantitative easing. On the opposite side of the trade, President Trump elected Jerome Powell as the next Fed chair who will most likely continue the rate hike path highlighted by Janet Yellen. This will add further upward pressure on USD/SEK. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Trades & Forecasts Forecast Summary Core Portfolio Closed Trades

Highlights London house prices have dropped 7% since the U.K. Government started the formal process of Brexit seven months ago. Stay underweight U.K. real estate and consumer services versus German real estate and consumer services. The global bond yield mini-cycle is driving asset allocation, sector allocation, value/growth allocation and country allocation. We are more than half way through the current mini-upswing in global bond yields. Look for opportunities to cut back overall portfolio cyclicality towards the end of the year. Feature London house prices have dropped 7% since the U.K. Government started the formal process of Brexit seven months ago (Chart of the Week). The average London home is now worth £584,000,1 down from £628,000. Moreover, our leading indicator for London house prices which compares the number of new viewings (demand) with the number of new listings (supply) suggests no imminent end to the sharpest price decline since the 2008 financial crisis (Chart I-2). Chart I-1Brexit Begins To Bite In London Brexit Begins To Bite In London Brexit Begins To Bite In London Chart I-2The Sharpest Decline In London House Prices Since 2008... The Sharpest Decline In London House Prices Since 2008... The Sharpest Decline In London House Prices Since 2008... Unsurprisingly, the many uncertainties surrounding the unfolding Brexit process are having a much greater impact on the London housing market than on the U.K. housing market as a whole. Outside London, the housing market is broadly flat-lining (Chart I-3). The average U.K. home outside London is now worth £256,500, modestly down from £260,000. Chart I-3 ...But Outside London, Prices Are Flat-Lining ...But Outside London, Prices Are Flat-Lining ...But Outside London, Prices Are Flat-Lining U.K. Households Squeezed We are writing ahead of the Bank of England monetary policy meeting, at which the BoE may deliver its first interest rate hike since July 2007. But hike or no hike, we can confidently say one thing: U.K. households will be squeezed. If the BoE does hike the base rate in an attempt to counter overshooting inflation, it could tip the precariously flat-lining housing market outside London into a downturn - as this market is much more exposed to mortgage affordability than it is to Brexit uncertainties. Alternatively, if the BoE does not hike the base rate, the boost to sterling from recent hawkish rhetoric will be priced out, and the pound will come under renewed downward pressure. This would keep U.K. inflation elevated, and further choke U.K. households' real incomes. Absent the post Brexit vote slump in the pound, U.K. inflation would be substantially lower than it is (Chart I-4 and Chart I-5). So the pound's weakness explains why the U.K. is one of the few major economies where inflation is running well north of 2%. Unfortunately for U.K. households, nominal wage inflation has not followed price inflation higher. And as we explained in Why Robots Will Kill Middle Incomes,2 nor is it likely to in the near future. Chart I-4The Weaker Pound Lifted U.K. Headline Inflation... The Weaker Pound Lifted U.K. Headline Inflation... The Weaker Pound Lifted U.K. Headline Inflation... Chart I-5...And U.K. Core Inflation ...And U.K. Core Inflation ...And U.K. Core Inflation But doesn't textbook economic theory say that the pound's weakness should make U.K. exports more competitive - thereby boosting the net export contribution to economic growth? Yes, the theory does say that a currency devaluation should allow firms to trade in markets that were previously unprofitable to them. However, to trade in these newly profitable markets, firms first need to invest - for example, in marketing and distribution. The trouble is that, post-Brexit, many of the newly profitable markets may be unavailable, or come with heavy tariffs. So firms will hold off making the necessary investments, unless the currency devaluation is massive. But in this case, the corresponding surge in inflation and choke on households' real incomes would also be massive. In summary, U.K. consumer spending faces a continued squeeze. If the BoE delivers a rate hike, household borrowing is likely to fade as a driver of spending. But if the BoE does not deliver the rate hike, the pound will once again weaken, keeping inflation elevated and weighing on real incomes. Stay underweight U.K. consumer services versus German consumer services (Chart I-6). And stay underweight U.K. real estate versus German real estate - expressed either through direct real estate exposure or through real estate equities (Chart I-7). Chart I-6U.K. Consumer Services Equities Are Underperforming U.K. Consumer Services Equities Are Underperforming U.K. Consumer Services Equities Are Underperforming Chart I-7U.K. Real Estate Equities Are Underperforming U.K. Real Estate Equities Are Underperforming U.K. Real Estate Equities Are Underperforming Investment Reductionism Illustrated Turning to markets more generally, it is crucial to understand that most of the moves in most financial markets reduce to a very small number of over-arching macro drivers. We call this very important principle Investment Reductionism. Investment Reductionism emerges from two guiding philosophies: Occam's Razor - which says that when there are competing explanations for the same effect, the simplest explanation is usually the best; and the Pareto Principle (the 80:20 rule) - which says that a small minority of causes usually explain a large majority of effects. The upshot of Investment Reductionism is that the seeming complexity of asset allocation, sector selection, the choice between value or growth, and country allocation usually reduces to something much simpler. Let's illustrate this. The global 6-month credit impulse leads the cyclical direction of the global bond yield, and thereby determines asset allocation (Chart I-8). The direction of the global bond yield drives sector selection: for example Banks versus Healthcare. This is because higher bond yields imply higher net interest margins for banks as well as an improving growth outlook, favouring cyclicals over defensives. And vice-versa (Chart I-9). Chart I-8Investment Reductionism Step 1: ##br##The Global Credit Impulse Leads The Bond Yield Cycle Investment Reductionism Step 1: The Global Credit Impulse Leads The Bond Yield Cycle Investment Reductionism Step 1: The Global Credit Impulse Leads The Bond Yield Cycle Chart I-9Step 2: The Bond Yield Drives ##br##Sector Performance Step 2: The Bond Yield Drives Sector Performance Step 2: The Bond Yield Drives Sector Performance Banks versus Healthcare determines the European Value versus Growth decision. This is because in Europe, Banks and Healthcare are the dominant value sector and growth sector respectively (Chart I-10). Banks versus Healthcare also determines the country allocation between, say, Italy's MIB - which is bank heavy - and Denmark's OMX - which is healthcare heavy (Chart I-11). Chart I-10Step 3: Sector Performance Drives Value ##br##Vs. Growth Step 3: Sector Performance Drives Value Vs. Growth Step 3: Sector Performance Drives Value Vs. Growth Chart I-11Step 4: Sector Performance Drives ##br##Country Performance Step 4: Sector Performance Drives Country Performance Step 4: Sector Performance Drives Country Performance Therefore, the important lesson from Investment Reductionism is to ignore the hundreds of things that matter little, and to focus on the very small number of things that matter a lot. And one of the things that matters a lot is the global bond yield mini-cycle. Where Are We In The Bond Yield Mini-Cycle? Empirically, the acceleration and deceleration of global bank credit flows - as measured in the global credit impulse - exhibits a remarkably regular wave like pattern, with each half-cycle lasting about 8 months (Chart I-12). The global bond yield shows a similarly regular wave like pattern with each half-cycle also averaging about 8 months (Chart I-13). Chart I-12The Global Credit Impulse Has Also Shown A Regular Wave Like Pattern The Global Credit Impulse Has Also Shown A Regular Wave Like Pattern The Global Credit Impulse Has Also Shown A Regular Wave Like Pattern Chart I-13The Global Bond Yield Has Shown A Regular Wave Like Pattern The Global Bond Yield Has Shown A Regular Wave Like Pattern The Global Bond Yield Has Shown A Regular Wave Like Pattern It is not a coincidence that the bank credit impulse and bond yield exhibit near identical half-cycle lengths. The global credit impulse and global bond yield are inextricably embraced in a perpetual mini-cycle. A stronger credit impulse boosts economic growth. In response to the stronger economic data, the bond yield rises, which slows credit growth. A weaker credit impulse weighs down economic growth. In response to the weaker economic data, the bond yield declines, which re-accelerates credit growth. Go back to step 1 and repeat ad perpetuam. At this moment, from an investment perspective, there are three points worth making: first, bond yield mini-upswings tend to occur mostly within the credit impulse upswing; second, credit impulse mini-upswings have a consistent duration lasting about 8 months; and third, the current mini-upswing started in May. What does this mean for investment strategy? It means that we are more than half-way through the current mini-upswing which we would expect to end around January/February. And at some point early next year we are likely to enter a mini-downswing. So it is slightly premature to cut back cyclical exposure right now. But we would certainly consider opportunities as we move to the end of the year - especially if our now tried and tested fractal timing indicators signal that the price action in specific investments has reached a technical tipping point. Stay tuned. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Source: LSL Acadata 2 Please see the European Investment Strategy Special Report "Why Robots Will Kill Middle Incomes", dated August 10 2017 available at eis.bcaresearch.com. Fractal Trading Model* This week, our model suggests that the New Zealand dollar is oversold and ripe for a technical rebound. The recommended trade is long NZD/USD with a profit target/stop loss set at 3%. In other trades, long Canada 10-year bond/short German 10-year bund achieved its profit target while short Norway/long Switzerland hit its stop loss. This leaves five open trades. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-14 Long NZD/USD Long NZD/USD * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com. Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Feature This week we are sending you a shorter-than-usual market update, as we are also publishing a Special Report exploring the outlook for USD cross-currency basis swap spreads. This report argues that USD basis swap spreads should widen over the next 12 months. Being a phenomenon associated with higher FX vols, this should hurt carry trades, including EM and dollar bloc currencies. It will also potentially create additional support for the USD. Also, next week, we will provide a deeper analysis of the fallout from the New Zealand government's dynamics. ECB Tapers? European Central Bank President Mario Draghi refused to call it "tapering," but he nonetheless announced that the ECB will be cutting back its asset purchases to EUR30 billion per month until at least September 2018. However, because the ECB will continue to proceed with re-investment of the stock of assets it holds, the monthly total presence of the ECB in European bond markets will stay above EUR 30 billion. Moreover, the ECB is keeping the door open to leaving its purchases in place beyond September 2019, if inflation does not keep track with the central bank's forecasts, and thus referred to the adjustment as being open-ended. Ultimately, the ECB does think that the recent rebound in inflation has been and remains a function of maintaining a very accommodative monetary setting. We think this option to keep the asset purchases in place beyond September 2018 is just this: an option. However, we do believe that yesterday's change in policy means the ECB will not increase interest rates until well into 2019. We also anticipate U.S. core inflation to begin outperforming euro area core inflation as U.S. financial conditions have eased significantly relative to the euro area - a key factor to redistribute inflationary pressures among these two economies (Chart I-1). As a result, because we anticipate that the Federal Reserve will increase the fed funds rate by more than the 67 basis points currently expected over the next two years, there could be some downside risk in EUR/USD. This downside risk is already highlighted by the large gap that has recently emerged between the 1-year/1-year forward risk-free rate spread between Europe and the U.S. versus the euro itself (Chart I-2). Chart I-1U.S. Inflation Set To Outperform Euro Area Prices U.S. Inflation Set To Outperform Euro Area Prices U.S. Inflation Set To Outperform Euro Area Prices Chart I-2Forward Interest Rates Point To A Lower Euro Forward Interest Rates Point To A Lower Euro Forward Interest Rates Point To A Lower Euro Moreover, the elevated long positioning right now further highlights the downside risk present in the euro (Chart I-3), probably explaining the European currency's rather violent reaction to what was a well-anticipated policy move. This means that EUR/USD could end 2017 in the 1.15 neighborhood, and fall further in 2018. Chart I-3Positioning Risk In EUR/USD Positioning Risk In EUR/USD Positioning Risk In EUR/USD Bottom Line: The ECB delivered exactly what was anticipated, yet the euro sold off. The ECB is unlikely to increase interest rates until well into 2019, suggesting the first anticipated rate hike in Europe is fairly priced. Thus, in order to justify any downside in the euro, one needs to be more positive on the Fed than what is currently priced into the U.S. interest rate curve. We fall into this camp. Moreover, positioning remains too long the euro. We expect EUR/USD to fall toward 1.15 by year end, and display more downside in 2018. Bank Of Canada The Bank of Canada (BoC) surprised the market this week by expressing a reversing of its recent pronounced hawkish bias, instead expressing a much more cautious tone. Where a closed output gap was once driving the need for tighter policy, residual labor market slack now warrants a more restrained approach to tightening. What has changed? NAFTA. The most recent and tenuous NAFTA negotiation round raised the specter of an end to the North American FTA. While NAFTA is still not dead, the rising probability that Canada-U.S. trade falls backs under the umbrella of the previous CUSFTA or even maybe something worse is causing a headache for Canadian policymakers. Some 20% of Canadian GDP is made up of products destined to be exported to the U.S., and this large chunk of GDP could be under some risk. Additionally, as the BoC highlighted, future investment decisions by firms in Canada may become investments in the U.S. to bypass regulatory uncertainty. Ultimately, if the Canada / U.S. trade relationship falls back under the CUSFTA umbrella, the impact on Canadian growth will be limited. Nonetheless, we think the BoC is correct to play its hand carefully, especially as the Canadian housing market is cooling. Moreover, a recent IPSOS survey revealed that around 40% of Canadian households would face financial difficulties if rates moved up significantly, which may justify a slower pace of hiking. With all this uncertainty looming, it is logical for the BoC to take its time before tightening policy anew. But in the end, we do anticipate the Canadian central bank to increase rates around two times next year, which is in line with the market's assessment: Canada's output gap is closing, and inflation is moving in the right direction. Thus, the outlook for the CAD is likely to be dominated by the outlook for oil. Robert Ryan, who runs BCA's Commodity And Energy Strategy service, expects WTI to move toward US$63/bbl next year, with upside risk to his forecast.1 This could help the CAD. However, the CAD does not seem particularly cheap against the USD when Canada's poor productivity performance is taken into account (Chart I-4), and speculators are now quite long the CAD (Chart I-5). As a result, our preferred medium to express positive views on the CAD is to be short AUD/CAD, where a valuation advantage is still present for the loonie (Chart I-6). Moreover, the AUD is more likely to suffer from China moving away from its investment-led growth model, while the CAD is less exposed to this risk. Chart I-4The CAD Is Not That Cheap The CAD Is Not That Cheap The CAD Is Not That Cheap Chart I-5Speculators Are Very Long The CAD Speculators Are Very Long The CAD Speculators Are Very Long The CAD Chart I-6Short AUD/CAD Short AUD/CAD Short AUD/CAD Bottom Line: The BoC is rightfully concerned that a breakdown of NAFTA would negatively affect the Canadian economy. While a return to CUSFTA would minimize any impact, the current high degree of uncertainty warrants that the BoC takes a more cautious stance. Ultimately, the BoC will increase rates next year, potentially two times. We continue to prefer to short AUD/CAD. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Commodity & Energy Strategy Weekly Report, titled "Upside Risks Dominate BCA's Oil Price Forecast", dated October 26, 2017, available at ces.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 U.S. data has been strong: Manufacturing PMI came out at 54.5, stronger than expected; Services PMI came out at 55.9, also stronger than expected; Durable goods orders increased by 2.2%; New home sales increased by 18.9% monthly, the highest growth rate in 25 years; Initial jobless claims declined and beat expectations. Crucially, the DXY is above its 100-day moving average and has broken the reverse head-and-shoulders neckline, with momentum in the greenback's favor. The ECB's tapering weakened the euro by 1.4%. Further weakness in commodity currencies also allowed the dollar to gain momentum. We expect this momentum to continue as inflation in the U.S. re-emerges over the next six to twelve months. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 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 ECB's decision was largely in line with market consensus, but the euro nonetheless fell significantly. The ECB will halve its rate of purchases to EUR 30 bn a month starting next year until at least September 2018. However, President Mario Draghi stated that this could be extended beyond September, or even increased, if conditions warrant it. Draghi noted that "domestic price pressures are still muted overall and the economic outlook and the path of inflation remain conditional on continued support from monetary policy", also stating that rates would remain low for an extended period of time, and possibly even "past the horizon of the net asset purchases". Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 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: The Leading Economic Index increased from 105.2 to 107.2 in the month of August. Nikkei Manufacturing PMI surprised to the downside, coming in at 52.5, declining from 52.9 the month before. However, corporate service prices year-on-year growth came in at 0.9%, against expectations of 0.8%. Following the overwhelming victory of Prime Minister Shinzo Abe, the USD/JPY traded above 114, before stabilizing just below later in the week. Now that Abe has won the election, he is freer to implement loose fiscal policy in order to increase his chances to amend the pacifist Japanese constitution. This, accompanied by 10-year JGB rates anchored around zero, and a Federal Reserve that is likely to hike more than expected, should push USD/JPY higher. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 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 Britain has been mixed: Gross Domestic product yearly and quarterly growth surprised to the upside, coming in at 1.5% and 0.4% respectively. Moreover, public sector net borrowing was also lower than expected coming in at 5.236 billion pounds for the month of September. However, BBA mortgage approvals came below expectations, coming in at 41.584 thousand, which is lower than the month before. The pound has gone up following the positive GDP reading. As of now the market considers there is a 91% probability that the Bank of England hikes rates in November. However any hikes beyond that would require a significant improvement in economic activity. Thus, we would tend to fade any strength in GBP/USD, as the Fed is more likely to hike rates than the BoE on a sustainable basis. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 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 declined on weak consumer price numbers. The trimmed mean CPI remained steady at 1.8% annually, below the expected 2% rate, and weakened to 0.4% quarterly, down from 0.5%. The largest yearly decline was in communication (services or equipment) of 1.4%, although declines in food prices and clothing were also substantial at 0.9%. This is largely in line with our view that the consumer sector is handicapped with poor wage growth. We believe inflation is unlikely to move much higher; this will keep the RBA at bay. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 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 negative: Imports surprised to the upside, coming in at 4.92 billion dollars. This figure also increased form last month's reading. However exports underperformed expectations, coming in at 3.78 billion dollars for the month of September. Finally the trade balance, also underperformed expectations, coming in at -1.143 billion dollars. After the election of new Prime Minister Jacinda Ardern the kiwi has plunged, and now has a negative return year-to-date. The government is trying to implement three measures which significantly affect the value of the kiwi: a dual central bank mandate, restrictions on immigration, and a stop to foreign real estate purchases. All these measures lower the terminal rate for the RBNZ. With this being said, we are still shorting AUD/NZD given that commodity dynamics will dominate the movements of this cross. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 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 CAD had an eventful week as the Bank of Canada came out with a monetary policy decision. The decision was in line with the consensus, but the statement was not. The Bank was particularly concerned "about political developments and fiscal and trade policies, notably the renegotiation of the North American Free Trade Agreement". Additionally, it was also noted that "because of high debt levels, household spending is likely more sensitive to interest rates than in the past". The Bank also made a U-turn in its view of the labor market, stating that "wage and other data indicate that there is still slack in the labor market". These unexpected remarks dropped the CAD's value by 1% against USD. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 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 The Franc continues to depreciate against the Euro, even as EUR/USD has gone down more than 2.5% since peaking early in December. Meanwhile, as the franc has depreciated, economic variables have improved. The KOF Industry Survey Business Climate indicator is now positive for the first time since 2011. Meanwhile, core inflation has reached 2011 highs as well. Additionally multiple components of PMI are at their highest level in the past 6 years. All of these factors bode well for the Swiss economy, and prove that the SNB's ultra-loose monetary policy and currency intervention is working. That being said, we would like to see more strength from key economic variables to consider shorting EUR/CHF, given that the recovery is still too fragile for the SNB to change policy. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 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 Norges Bank left their key policy rate unchanged at 0.5% yesterday. The central bank highlighted that capacity utilization was below normal levels and that inflation was expected to be below 2.5% in the coming years. Furthermore, the comittee highlighted that although the labor market appears to be improving, inflation has been lower than expected, while the krone is also weaker than projected. The bank has reassured our view that even in the face of strong oil prices, slack is still too big in the Norwegian economy for the Norges Bank to start raising rates. Furthermore, a hawkish fed will further put upward pressure on USD/NOK. Than being said, EUR/NOK should depreciate, given that this cross is much more sensitive to oil than it is to rate differentials. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 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 SEK has depreciated considerably in recent weeks owing to somewhat weaker inflation figures. It has weakened particularly against the EUR, as markets are expecting the Riksbank to follow the ECB in its rate path. This was confirmed by a particularly dovish tone from the recent monetary policy statement which exacerbated this decline, with the board expecting to maintain the current monetary policy until mid-2018, and even discussed a possible extension of asset purchase programs beyond December. The Board has "also taken a decision to extend the mandate that facilitates a quick intervention in the foreign exchange market". Finally, they lowered their inflation forecasts for both 2017 and 2018. Stefan Ingves is firmly in control. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades