Europe

Highlights On the European side, the key risk to our bullish DXY stance is that European growth is strong, the labor market seems to be tightening, and core CPI has perked up. These risks are real but mitigated by budding signs that European growth is at its best, by the abundance of hidden labor market slack, and by the high chance that the CPI spike was transitory. On the U.S. side of the ledger, the key risks are that wages do not pick up, that credit growth continues to act as a break on activity, and that political risks hamper fiscal dynamics. All would mean a more dovish Fed than we anticipate. These risks are mitigated by the fact that hidden U.S. labor market slack is only now low enough for wages to improve, credit looks set to turn around as financial conditions are supportive, and fiscal policy should surprise to the upside. USD/NOK has upside as Norway experiences declining inflation. Go long CAD/NOK. Feature Last week, we augmented our cyclically dollar bullish view by removing our tactical bearish bias on the USD. In our eyes, the market is underestimating the capacity of the Fed to increase rates and is also overestimating the economic impact of the fiasco surrounding Trump's alleged relationship with Russia. Despite our high conviction view that the dollar can rally 10% or more from current levels, we cannot be blind to the key risks surrounding it. This week, we explore where our stance on Europe and the Fed can go wrong. ECB Tapering = Upcoming Tightening Campaign? The key risk to our negative euro stance is the ECB. The market has moved to discount the first rate hike in Europe to happen in barely two years, an event we judge highly unlikely. However, if the market is right that a tapering of asset purchases in 2018 and a potential increase in the rates on deposit facilities to 0% are the opening salvos of an imminent campaign to push up the repo rate, the EUR/USD rally is only in its early days. Here are the key factors that would support this bullish euro view: The European economy is in a major economic upswing. Not only have PMIs surged, the IFO has hit an all-time high (Chart I-1). If this pace of growth can be maintained for an extended period of time, the European output gap will close faster than we anticipate, providing a stronger basis for the ECB to nudge all rates higher. The euro area labor market is tightening. Euro area unemployment rate is at 9.5%, only 0.7% above the OECD's estimate for NAIRU (Chart I-2). Thus, it would paint a picture where there is little slack in the economy at large and in the labor market in particular. In this environment, a continuation of the elevated growth currently experienced by the euro area could boost wages. Core inflation has picked up to 1.2% (Chart I-3). The ECB has historically displayed a tight reaction function to inflation. In the past, headline CPI mattered, but since Mario Draghi took the helm of this institution, the focus has switched to underlying pricing pressures. Thus, if euro area core inflation continues to move up, especially as U.S. core PCE inflation has weakened to 1.6%, the market will be vindicated and the euro could rebound on a more hawkish ECB. Chart I-1Europe Is Booming Europe Is Booming Europe Is Booming Chart I-2Low Labor Market Slack In Europe Low Labor Market Slack In Europe Low Labor Market Slack In Europe Chart I-3That Should Help The ECB To Hike That Should Help The ECB To Hike That Should Help The ECB To Hike Why Are These Factors Risks And Not Base Cases? To begin with, these factors have been discounted by the markets, a fact highlighted by the 42-month fall in the month-to-hike for the ECB since July 2016 to 24 months today. Also, as the European surprise index has outperformed the U.S. one, EUR/USD has rallied by 6%. In the process, investors have switched from being massively short the euro to being the most aggressively long in three years (Chart I-4). Risk-reversals in EUR/USD options are also at elevated levels, highlighting the potentially too-bullish disposition of investors toward the euro. On the growth front, some factors suggest that European growth may soon peak. The large improvement in the amount of industrial activity and capacity utilization in Europe relative to the U.S. was reflective of the big easing in monetary conditions that followed the collapse of the euro after 2014. But, as Chart I-5 illustrates, European industrial production needed a falling euro to beat that of the U.S., soon after the euro stabilized, the growth outperformance began to recede and is now near inexistent based on this metric. Thus, the euro rebound removes one of the key factors that supported the European economy in the first place. Chart I-4Investors Have Discounted##br## The Good News In Europe Investors Have Discounted The Good News In Europe Investors Have Discounted The Good News In Europe Chart I-5Europe's Growth Outperformance ##br##Was Because Of Policy Europe's Growth Outperformance Was Because Of Policy Europe's Growth Outperformance Was Because Of Policy Additionally, some economic data are showing disturbing signs. While Germany's IFO stands at a record high, Belgian business confidence has rolled over. In fact, export orders have been particularly weak (Chart I-6). This is of importance as Belgium has long been a logistical center for the euro area, and is a small open economy deeply integrated in the European economic infrastructure. This, therefore, portends to emerging risks to the whole euro area. Monetary dynamics too raise questions. European business confidence, a key piece of soft data that has underpinned investors increased bullishness on the euro is led by dynamics in M1 money supply. The roll over in M1 implies that business conditions in Europe are slowly passing their best period (Chart I-7). If euro area growth peaks, this also raises concerns about the state of the labor market. This is especially worrisome as we think the unemployment gap based on the OECD's estimate of NAIRU misses key elements of the European labor market slack. As we wrote last week, the key problem in Europe is labor underutilization; hidden labor market slack remains a serious concern.1 With workers in irregular contracts being a key source of job creation since the end of the 2013 recession, there are plenty of workers willing to change jobs without the incentive of a higher pay, limiting the upside in wages. Without wage growth, it will be difficult for European core inflation to continue its uptrend, especially as there are many signs that the rebound that has excited investors' imagination may have been a transitory event. Worryingly for euro bulls, our Core CPI A/D line for Europe, which tends to lead core CPI itself, rolled over last year and points to lower core CPI.2 Industrial good prices excluding energy have also been weakening for 15 months now, suggesting this inflation rebound may be an aberration (Chart I-8). Chart I-6Where Belgium Goes, ##br##So Does Europe Where Belgium Goes, So Does Europe Where Belgium Goes, So Does Europe Chart I-7Money Trends Point To A Deceleration##br## In European Soft Data Money Trends Point To A Deceleration In European Soft Data Money Trends Point To A Deceleration In European Soft Data Chart I-8Europe Core CPI ##br##Will Roll Over Europe Core CPI Will Roll Over Europe Core CPI Will Roll Over Bottom Line: Investors have become very bullish of the euro based on the fact that the economy has been very strong, the European headline unemployment rate is moving closer to NAIRU, and core inflation has perked up; raising the specter of high rates sooner than we anticipate. These economic developments need to be monitored closely, but the growth impulse in Europe is likely to soon deteriorate, broader measures of labor market slack in the euro area are far from being at full employment, and the tick up in core inflation is likely to prove to have been only a temporary blip. These forces should weigh on the euro for the rest of 2017. Maybe The Fed Will Not Tighten That Much? Meanwhile, in the U.S., investors only expect three rate hikes over the next 24 months. Markets have begun doubting the fed's capacity or resolve to hike interest rates as aggressively as we envision. A slew of disappointing data and political developments have cemented this opinion among investors. Among the most crucial factors are the following: Chart I-9Disappointing U.S. Wages Dissipating U.S. Wages Dissipating U.S. Wages Wage growth in the U.S. remains poor, especially as per average hourly earnings which are still only growing at a disappointing 2.3% rate (Chart I-9). This raises the specter that consumption will remain tepid and that inflationary dynamics will never take hold in the U.S. This risk is perceived as especially salient as core inflation and core PCE have slowed below the 2% objective of the FOMC. Slowing credit growth has also garnered a lot of attention among the public. Credit is the life blood of the economy, and this slowdown has prompted many investors to begin questioning whether or not the U.S. economy would ever be able to take off. This compounded worries around the perennially weak Q1 GDP growth. Finally, the myriad of scandals surrounding Trump and his dealings with Russia have raised much questions about his ability to ever implement fiscal stimulus. Moreover, the punitive terms associated with the repeal of Obamacare and the implementation of the American Health Care Act (AHCA) - which according to the CBO could leave as many as 23 million individuals without health insurance by 2023 and cause sharp increases in insurance premia - may dull any growth boosting impact of potential tax cuts. Thus, the political backdrop may prompt the Fed to be easier than was anticipated as recently as December 2016. Why Are These Factors Risks And Not Base Cases? To begin with, BCA still hold the view that wages in the U.S. are set to accelerate in the coming quarters. The Phillips Curve continues to be a reality, as the Atlanta Fed Wage Tracker still display a tight relationship with the unemployment gap (Chart I-10). Moreover, it is often argued that the problem with today's labor market is that much of the job creation is happening in low-skilled positions. This is true, but historically, low-skilled jobs have tended to experience the most upward pressures when the job market tightens significantly. Instead, the key anchor on average hourly earnings has been the hidden labor market slack. However, today, the U-6 unemployment rate is finally ticking at 8.6%, levels where in previous cycles wage growth accelerated (Chart I-11). A rebound in GDP growth, as highlighted by the Atlanta Fed growth forecast of 4.1% in Q2, would accentuate pressures on the labor market and help realized the underlying wage pressures resulting from the current readings of the U6 unemployment rate. Chart I-10The Phillips Curve: It's Alive The Phillips Curve: It's Alive The Phillips Curve: It's Alive Chart I-11U.S. Wages Will Pick Up U.S. Wages Will Pick Up U.S. Wages Will Pick Up What could support growth? Let's begin with the credit dynamics. As we have argued, credit growth is a lagging indicator of economic activity. The improvement in the ISM through 2016 and early 2017 continues to point to a rebound in C&I loans in the U.S. (Chart I-12). Moreover, aggregate bank credit in the U.S. is already re-accelerating, suggesting that credit will once again add to economic activity, and will stop subtracting from it (Chart I-13). Chart I-12Credit Lags, And It Will Pick Up Credit Lags, And It Will Pick Up Credit Lags, And It Will Pick Up Chart I-13Momentum In U.S. Loans Is Turning Up Momentum In U.S. Loans Is Turning Up Momentum In U.S. Loans Is Turning Up Another positive for the U.S. economy has been the substantial easing in financial conditions resulting from the fall in the dollar and bond yields since the beginning of 2017. This easing should help economic activity over the course of the next quarters (Chart I-14). In its most recent minutes, the Fed has alluded to these forces. The fall in the dollar is already showing signs of helping. The ISM export orders index is currently ticking near 60, suggesting that the fall in the USD has had a stimulative impact on the U.S economy (Chart I-15). This is especially salient when contrasted with the euro area industrial production dynamics described above. Chart I-14U.S. Financial Conditions Will Help Growth U.S. Financial Conditions Will Help Growth U.S. Financial Conditions Will Help Growth Chart I-15The Dollar's Easing Is Evident The Dollar's Easing Is Evident The Dollar's Easing Is Evident Finally, when it comes to fiscal policy, our Geopolitical Strategy team remains adamant that tax cuts will materialize in the coming quarters. It is becoming imperative for congressional Republicans to achieve this as Trump's popularity remains dismal at the national level, which could prompt a serious electoral rout in the 2018 mid-term elections (Chart I-16). This means that fiscal easing is likely to come through, which should have an impact on asset prices and the dollar: The DXY is back to pre-election levels and the relative performance of stocks most sensitive to changes in tax policy is back to January 2016 levels. These price trends indicate that investors have massively curtailed their expectations for governmental support to growth. Chart I-16If Tax Cuts Don't Pass, Republicans Are Heading For A Huge Defeat In 2018 Exploring Risks To Our DXY View Exploring Risks To Our DXY View Moreover, the current format of the AHCA is unlikely to make it through the more moderate U.S. Senate. The loss of coverage and the insurance premia increases implied by the current plan are likely to be electoral poison in 2018, something well understood by key GOP policymakers. An AHCA still up in the air does not preclude tax cuts either. The budget deficit hole created by unfunded tax cuts will likely be patched through aggressive growth assumptions, the magic of dynamic scoring. The recently revealed Trump budget proposal itself is also unlikely to see the light of day in its current form and will evolve toward something more supportive of growth as time and negotiations pass. Bottom Line: Investors have massively curtailed their expectations of Fed tightening over the next two years. This view has been based on the lack of wage acceleration in the U.S., the poor credit growth numbers, and the uncertainty surrounding fiscal policy. These are still important risks to our bullish stance. However, we remain optimist because wage growth is only set to increase now, credit is a lagging indicator that looks about to pick up anew, financial conditions should help future U.S. economic activity, and the potential for tax cuts is far from dead. Stay long DXY. Norway's Passing Inflation Problem It was not long ago when the Norges Bank was facing the daunting task of kick starting a Norwegian economy ravaged by the collapse in oil prices while trying to contain the high inflation brought upon by the sell-off in the krone. However, following the stabilization of the NOK, this dilemma has dissipated as multiple measures of inflation have plunged. The Norges Bank is now free to maintain its dovish bias as the economy remains tired and will require easy monetary to recover going forward. Based on the effect of currency moves, inflation might reach a bottom at the beginning of next year, but it will likely stay below the central bank's target of 2.5 % for the foreseeable future (Chart I-17). Indeed, in spite of the rebound in oil prices, employment is contracting, the output gap is large, and wage growth remains deeply negative (Chart I-18). The Norges Bank is sympathetic to this view, acknowledging in its most recent monetary policy statement that inflation will hover in a 1-2% range in the coming years. Chart I-17A Stable NOK Will Keep Inflation Subdued A Stable NOK Will Keep Inflation Subdued A Stable NOK Will Keep Inflation Subdued Chart I-18No Domestic Inflationary Pressures In Norway No Domestic Inflationary Pressures In Norway No Domestic Inflationary Pressures In Norway Lastly, Norway's bubbly real estate market, the last obstacle to the Norges Bank dovish bias, is finally slowing down. Thanks to changes in regulation on residential mortgage lending at the start of the year, banks are tightening lending standards to households, a precursor to a cooling housing market (Chart I-19). With a Fed looking to increase rates, the real rate differential between the U.S. and Norway should move in favor of USD/NOK. Yet, could rising oil prices deepen the USD/NOK weakness? This seems doubtful as USD/NOK continues to be more correlated with real rate differentials than with the price of oil (Chart I-20). Nevertheless, the outlook of the krone against the AUD and the NZD is much more promising: Chart I-19No Need To Raise Rates To Curb Housing Prices No Need To Raise Rates To Curb Housing Prices No Need To Raise Rates To Curb Housing Prices Chart I-20Real Rates Matter More Than Oil Real Rates Matter More Than Oil Real Rates Matter More Than Oil Yesterday, OPEC Russia agreed to maintain their production cuts in place for the next nine months. This deal should keep the oil market in a deficit, pushing oil prices up and providing a tailwind to the NOK against non-oil commodity currencies. Chart I-21CAD/NOK: A Call On The U.S. Dollar CAD/NOK: A Call On The U.S. Dollar CAD/NOK: A Call On The U.S. Dollar On the other hand, the outlook for industrial metals and other commodities, which are more sensitive to the Chinese economy, continues to be worrying. Monetary conditions are still tightening in China and multiple economic activity indicators have disappointed to the downside. While base metals have already fallen considerably, we believe that additional weakness in the Chinese economy will trigger a selloff in EM assets, bringing the NZD and the AUD down with them. Finally, it may be time to sell the NOK against the CAD. The Bank of Canada struck a hawkish tone on Wednesday, stating that the Canadian economy's adjustment to lower oil prices is largely complete and that consumer spending should be supported by an improving labor market. This change in rhetoric should set the stage for a rally in CAD/NOK. Moreover, our Intermediate-Term Timing Model shows that this cross is 7% cheap, and our bullish USD view implies an outperformance of the loonie versus the krone given the tight correlation between CAD/NOK and the DXY (Chart I-21). Bottom Line: Outperformance of oil in the commodity space will help the krone outpace non-oil commodity currencies. However, the Norges Bank is likely to keep a dovish bias, which should make it difficult for the NOK to rally durably against a cheap U.S. dollar. Go long CAD/NOK. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Juan Manuel Correa Research Analyst juanc@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report titled "Bloody Potomac", dated May 19, 2017, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report titled "The Achilles Heel Of Commodity Currencies", dated May 5, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 The greenback suffered some losses following the release of Fed minutes. Puzzlingly, the rhetoric was not dovish, as markets and news outlets confirmed the prospect for a June rate hike. The result was a dollar selloff and a drop in yields. This easing in financial conditions created an additional fillip for the S&P as it traded at a record high, the opposite of what is expected with a looming rate hike. As new home sales contracted on a monthly basis and the manufacturing PMI disappointed, the U.S. soft patch continues. Nevertheless, our base case remains on par with the Fed's: the weakness in data is temporary and the Fed will hike more than the markets expect. We are already seeing this as continuing and initial jobless claims beat expectations at 1.923 million, and 234,000 respectively, and the greenback has found a footing at the 97.1 level. As this scenario further unfolds, gold will retreat as real returns increase, and the greenback will gain upward momentum. Report Links: Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 The euro area continues to surprise with better than expected data: German IFO: Overall Business Climate came in at 114.6 - levels last seen in 1970; Expectations came in better than expected at 106.5; and the Current Assessment also beat expectations of 121.2, coming in at 123.2. Euro area Manufacturing PMI is at 57 for May, beating expectations of 56.5, and the Composite measure also recorded an outperformance, coming in at 56.8. On the consumer side, German Gfk Consumer Confidence Survey came in at 10.4, beating expectations of 10.2. While the euro to be overvalued on short-term metrics, and the euro area is structurally weaker than the U.S., weaker data needs to be seen for the markets to see a correction. Report Links: Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data has been negative in Japan: Manufacturing PMI decreased to 52 in May from 52.7 in April. Exports growth decreased to 7.5%, from 12% the month before and underperforming expectations. Japan's all industry activity Index also underperformed expectations, contracting by 0.6% MoM. We continue to believe that Japanese economic activity will ultimately be determined by the exchange rate. The yen has appreciated since this the start of the year, therefore it is understandable that inflation and economic activity have been subdued. Taking this into account, the BoJ will continue to target a yield of 0% in JGB's, and thus the yen should suffer on a cyclical basis given that real rates differentials with the U.S. will continue to widen. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 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 British data has been mixed: GDP growth underperformed, coming in at 2%, decreasing from last quarter and underperforming expectations, mostly reflecting poor trade numbers. Meanwhile total business investment grew by 0.8%, outperforming expectations. We are not positive on the pound against the dollar, given that near 1.3 the pound is no longer a bargain tactically. On the other hand we expect more upside against the euro. Powerful inflationary pressures are building in the U.K., and governor Carney, previously concerned about the effects of Brexit in the economy, might be more inclined now to deal with inflation as the U.K. has proved resilient. This will put upward pressure in British rates vis-à-vis European rates. Additionally EUR/GBP has reached overbought levels, indicating it might be a good time to short this cross. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 Updating Our Long-Term FX Value Models - February 17, 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 As the greenback's descent slowed down, so did the Aussie's ascent. The underlying motives for strength in the antipodean currency are misplaced. As data remains unpromising, this week followed through with further disappointments as overall construction work done contracted by 7.2% on an annual basis, with the engineering component contracting by 13%. Research by the RBA illustrates that construction work has a very close relationship with the national accounts of Australia. This could result in a slowdown in the economy - something which the RBA cannot afford amidst flailing inflationary pressures. On a more optimistic note, the commodity selloff is taking a breather. Most crucially for the AUD, iron ore futures have remained flat for almost a month after a 30% depreciation, and natural gas has been flat for almost a month. These developments have limited the AUD's downside for now. However, looming EM risks and the potential resumption of the dollar bull market represent very real risks for the AUD going forward. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 AUD And CAD: Risky Business - March 10, 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 kiwi has appreciated by about 1.5% against the dollar this week. Additionally, recent data has been positive: Visitor Arrivals yearly growth skyrocketed to 21.5% on April. The trade balance outperformed expectations coming in at -3.48 Billion The kiwi economy continues to surge, with 7% growth in nominal GDP and retail sales growth at decade-highs. Additionally, dairy prices continue to surge, and are now growing at a 60% YoY pace. For this reason we are bearish on AUD/NZD, as the Australian economy is not only in a more precarious state, but is also more sensitive to the Chinese industrial cycle. Meanwhile, we continue to be bearish on NZD/USD, as a negative view on EM assets necessarily entails a bearish view on the kiwi. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 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 Following on from the dollar's weakness, the CAD displayed further strength after the BoC's decision statement. While keeping rates unchanged, the bank highlighted that "recent economic data have been encouraging" and that "consumer spending and the housing sector continue to be robust on the back of an improving labor market". Furthermore, the Bank more or less expects these supports to growth to "strengthen and broaden over the projection horizon". While wholesale sales increased by less than expected at 0.9%, the BoC also expects that the "very strong growth in the first quarter will be followed by some moderation in the second quarter". This is likely to keep market expectations anchored and the CAD's value intact. Additionally, oil should pare recent weaknesses as OPEC follows through on its cuts. The CAD is therefore likely to see some strength against other commodity currencies. Report Links: Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 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 EUR/CHF has continued to depreciate after coming close to reaching 1.1. We continue to be negative on this cross, as the Euro is likely to have limited upside from current levels. The ECB is unlikely to hike rates any time soon, as wage pressures outside of Germany continue to be muted. Furthermore, this is not likely to change any time soon, as the labor market of the periphery continues to be very rigid. Meanwhile, the SNB is likely to take off the floor from this cross next year, as core inflation and retail sales growth have both returned to positive territory. We will continue to monitor the rhetoric by the SNB to have a more clear understanding of when the removal of the floor might occur. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 Updating Our Long-Term FX Value Models - February 17, 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 krone has rallied this week, thanks to the rise in oil prices. However real rate differentials should continue to move in favor of USD/NOK. While the fed is likely to hike more than what is currently anticipated in the OIS curve, the Norges Bank will stay dovish, given that the Norwegian economy is still too weak to sustain a rise in interest rates. Furthermore, macro prudential measures seem to be helping the Norges bank to slow down the housing market. The NOK is also likely to have downside against the CAD. The dollar bull market should help this cross rally, given the tight correlation between CAD/NOK and the DXY. Furthermore the BoC has struck a more hawkish tone as of late, which should further increase the difference between interest rate expectations in these two countries. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits -December 16, 2016 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Positive data emerged from Sweden this week as consumer confidence picked up to 105.9 from 103.7, beating expectation of a decline to 103.6. The seasonally-adjusted unemployment rate remains on a structural downtrend, coming in at 6.6% according to Statistics Sweden. In terms of crosses, USD/SEK continues to weaken due to the greenback's instability. EUR/SEK has topped out and is also showing some weakness. Against commodity currencies, the movement is mixed. The SEK has shown the most strength against the AUD, while CAD/SEK and NZD/SEK have been flat, and NOK/SEK has seen considerable strength on the back of robust oil prices. We can see the SEK being weak against oil-based currencies as we expect OPEC to remain focused on cutting global oil inventories, while AUD/SEK could see further downside due to poor fundamentals in Australia. Report Links: Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Fiscal policy is likely to be eased modestly in most advanced economies over the next two years. The U.S. Congress will ultimately cut taxes, although the size of the cuts will be far smaller than what President Trump has proposed. Ironically, fiscal stimulus is coming to America just when the economy has reached full employment. The market is pricing in too little Fed tightening over the remainder of the year. The dollar's swoon is ending. Go short EUR/USD with a target of parity by the end of the year. Feature Fiscal Thrust Around The World In its latest Fiscal Monitor, the IMF estimated that advanced economies eased fiscal policy by 0.2% of GDP in 2016, reversing a five-year streak of fiscal tightening (Chart 1). The Fund expects a further 0.1% of GDP of easing in 2017, followed by a neutral stance in 2018. In the EM universe, the IMF foresees a fiscal thrust1 of -0.2% of GDP in 2017 and -0.4% of GDP in 2018. Chart 1IMF Expects Modest Fiscal Easing In Advanced Economies, Further Tightening In EM Fiscal Policy In The Spotlight Fiscal Policy In The Spotlight Averages can disguise a lot of variation across countries (Charts 2). Comparing 2018 with 2016, the IMF expects Canada and the U.S. to experience a positive fiscal thrust of 0.7% of GDP and 0.4% of GDP, respectively. The fiscal thrust is projected to be -0.2% of GDP in the euro area, -1% of GDP in the U.K., and -0.5% of GDP in Japan. Among the larger advanced economies, Australia is expected to experience the largest degree of fiscal tightening, with a fiscal thrust of -1.2% of GDP. Across the EM universe, most of the fiscal tightening is projected to occur among oil producers. The IMF expects oil-exporting economies to collectively reduce their fiscal deficits by US$150 billion between 2016 and 2018. Political considerations require that the IMF give considerable weight to the stated objectives of governments when formulating fiscal projections. In reality, governments often struggle to meet their budget targets. Consequently, the Fund has typically overestimated the degree of fiscal consolidation that ends up happening (Chart 3). As such, our own projections foresee somewhat less fiscal tightening - and in some countries, a fair bit of fiscal easing - than the IMF projects. In particular: Chart 2Countries Will Follow Different Fiscal Paths Fiscal Policy In The Spotlight Fiscal Policy In The Spotlight Chart 3IMF Forecasts Tend To Overestimate Extent Of Fiscal Consolidation Fiscal Policy In The Spotlight Fiscal Policy In The Spotlight We do not expect much more incremental fiscal tightening out of the euro area. Thanks to a slew of austerity measures, the euro area's structural primary budget balance went from a deficit of 2.6% of GDP in 2010 to a surplus of 1.0% of GDP in 2014. It has remained close to those levels ever since. Now that a primary surplus has already been achieved and interest rates and bond spreads have fallen to exceptionally low levels, the need for further belt tightening has abated. That's the good news. The bad news is that high government debt levels in many European economies rule out any major new stimulus programs (Chart 4). The U.K. will slow the pace of fiscal consolidation. The U.K.'s structural primary budget deficit fell from a peak of 7.1% of GDP in 2009 to 1.3% of GDP in 2016. The IMF expects the primary balance to move into a surplus of 0.6% of GDP in 2019. We think that's unlikely. The Conservatives are under intense pressure to keep the economy afloat during Brexit negotiations. Prime Minister Theresa May has indicated she will delay eradicating the budget deficit until the middle of the next decade, having previously promised a 2020 target date. Japan has limited scope to further tighten fiscal policy. Japan's structural primary budget deficit reached 6.9% of GDP in 2010. The IMF expects it to reach 3.7% this year and fall further to 2% in 2020, provided the government goes forward with raising the VAT from 8% to 10%. We are skeptical that Japan's economy will be strong enough to allow the government to raise taxes. However, even if it is, this will only be because the Bank of Japan gooses growth by keeping long-term yields pinned to zero, thereby allowing the yen to depreciate further. China is making a structural transition to large budget deficits. The IMF estimates that China's structural primary budget balance deteriorated from a surplus of 0.1% of GDP in 2014 to a deficit of 2.8% of GDP in 2016. The increase in the fiscal deficit cannot be explained by the reclassification of off-budget spending as on-budget, since the IMF's "augmented" fiscal balance - which attempts to control for such statistical issues - deteriorated by roughly the same amount (Chart 5). Part of the erosion in China's fiscal balance stemmed from the global manufacturing slowdown in 2015-2016, which hit tax receipts and necessitated a healthy dose of fiscal stimulus. However, there is more to the story than that. As we controversially argued in "China Needs More Debt," now that China is no longer in a position to run gargantuan current account surpluses, large fiscal deficits will be necessary to absorb excess private-sector savings.2 The government's desire to rein in credit growth will only add to the impetus to find new sources of aggregate demand. The era of red ink has begun. Chart 4Government Debt Levels Outside Of Germany Are Still High Government Debt Levels Outside Of Germany Are Still High Government Debt Levels Outside Of Germany Are Still High Chart 5China's Fiscal Deficit Has Been Increasing Fiscal Policy In The Spotlight Fiscal Policy In The Spotlight The U.S. Congress will ultimately cut taxes, although the size of the cuts will be far smaller than what President Trump has ambitiously proposed. After a wave of euphoria following the presidential election, the market has largely priced out meaningful fiscal stimulus. This can be seen in the flagging relative performance of infrastructure stocks and highly-taxed companies, as well as in the sharp decline in inflation expectations (Chart 6). We think this pessimism is overdone. Donald Trump desperately needs a "win," and cutting taxes is one key area where the President and Congress both see eye to eye. Trump's falling poll numbers have heightened the risk that the Republicans will lose control of the House of Representatives next November (Chart 7). This makes passing a tax bill before the midterm elections all the more urgent. The main questions surround the scale and scope of any tax cuts, and just as critically, how they are paid for. We discuss these issues next. Chart 6Markets Have Priced Out Meaningful Fiscal Stimulus Markets Have Priced Out Meaningful Fiscal Stimulus Markets Have Priced Out Meaningful Fiscal Stimulus Chart 7Challenging Outlook For Republicans In 2018 Fiscal Policy In The Spotlight Fiscal Policy In The Spotlight Trump's Budget Proposal: Fake Math Chart 8Trump In Wonderland? Fiscal Policy In The Spotlight Fiscal Policy In The Spotlight If the definition of a good leader is one who underpromises and overdelivers, then President Trump's budget proposal left much to be desired. Trump's plan assumes that U.S. growth will reach 3% over the next ten years. Even in the unlikely event that the economy manages to avert a recession over this period, such a growth rate would be a remarkable feat. After all, growth has averaged only 2.1% since 2009. And keep in mind that the unemployment rate has fallen from 10% to 4.4% over this interval, consistent with potential GDP growth of only 1.4%. The slow pace of capital accumulation following the Great Recession undoubtedly hurt the supply side of the economy, but it would take a phenomenal - and rather implausible - acceleration in potential GDP growth to justify Trump's 3% target. Many of the other assumptions in Trump's blueprint are no less dubious (Chart 8). Despite projecting much slower growth, the Federal Reserve expects short-term rates to rise to 3% in 2019. In contrast, the Trump administration sees rates increasing to only 2.4%, an assumption that perhaps not coincidentally helps reduce projected debt-servicing costs. Most flagrantly, the plan assumes no decline in the revenue-to-GDP ratio, even though the basis for faster growth largely rests on the assumption of steep tax cuts. When pressed on the issue, officials from the Office of Management and Budget sheepishly noted that there would be offsetting limits on tax deductions, which would have the effect of broadening the tax base. However, no specific information was given on what these would entail. Many theories have been offered as to why Trump offered such an outlandish budget plan. Was he trying to appease conservatives in Congress? Perhaps this was just a sly attempt to gain leverage in future budget negotiations? Our theory is simpler: Trump promised an economic boom during the election campaign, while assuring voters that his tax cuts would more than pay for themselves. Hell would need to freeze over before he released a plan that did not share these assumptions. Congress Will Decide So where do we go from here? The specifics of Trump's plan are irrelevant. Congress will rewrite the budget from scratch. Major spending cuts will be scrapped. So will the onerous cuts to insurance subsidies and Medicaid in the House version of the health care bill. The Senate will ditch those. In contrast, Trump's tax cuts will be preserved, albeit on a smaller scale than envisioned in his budget proposal. Granted, congressional leaders have said they want tax reform to be revenue neutral, meaning that any tax cuts would need to be offset by other revenue-raising measures. That is easier said than done, however. The three main ways that House Republicans have offered to pay for corporate and personal tax cuts - introducing a border adjustment tax, eliminating the deductibility of business interest payments, and jettisoning the deduction for state and local income taxes for individuals - all face severe resistance from vested interests. In Washington, where there is a will there is usually a dishonest way. Budget forecasts are typically made over a 10-year window. Thus, it is possible to lower taxes upfront and promise spending cuts and ill-defined revenue raising measures in the tail end of the budget window. Such a strategy would generate a positive fiscal thrust early on, while leaving the door open for Congress to dump any future spending reduction or revenue measures before they are actually implemented. Add to that the tax revenue that is projected to pour in from supply-side reforms, and the stage is set for a dollop of fiscal easing starting in early 2018. How likely is it that Republicans will pursue such a strategy? Very likely. As evidence, look no further than the fact that White House budget director Mick Mulvaney floated the idea on Wednesday of extending the 10-year budget scoring window to 20 years. Investment Conclusions Chart 9Phillips Curve Is Alive And Well Phillips Curve Is Alive And Well Phillips Curve Is Alive And Well An obsessive focus on fiscal austerity hamstrung the recovery in many countries following the Great Recession. The irony is that fiscal stimulus is coming to America just when the economy has reached full employment. This means that much of the increase in aggregate demand arising from a more expansionary fiscal stance will be reflected in higher inflation rather than faster growth. This does not represent a major threat to risk assets now, but could later next year. Despite all the obituaries that have been written for the death of the Phillips curve, the data show that it is alive and well (Chart 9). Higher inflation will allow the Fed to raise rates once per quarter. The market is not prepared for this. Investors currently expect only 45 basis points in rate hikes over the coming 12 months. That is far too low. On the other side of the Atlantic, the ECB's months-to-hike measure has plummeted from 65 months in July 2016 to only 24 months today (Chart 10). Real rates are projected to be a mere 14 basis points higher in the U.S. than in the euro area in five years' time (Chart 11). Chart 10The Big Shift In Market Sentiment Towards ECB Policy The Big Shift In Market Sentiment Towards ECB Policy The Big Shift In Market Sentiment Towards ECB Policy Chart 11The Vanishing Transatlantic Bond Spread Fiscal Policy In The Spotlight Fiscal Policy In The Spotlight Poor demographics and high private-sector debt levels imply that the neutral rate of interest is lower in the euro area than in the U.S. And while the euro area may not be tightening fiscal policy any longer, the fact that its structural primary budget balance is 2.6% of GDP larger than America's means that the euro area's overall fiscal stance will contribute less to aggregate demand than in the U.S. This will force the ECB to keep rates lower for longer, causing the euro to weaken. Chart 12Widening Real Rate Differentials ##br##Support The Dollar Widening Real Rate Differentials Support The Dollar Widening Real Rate Differentials Support The Dollar Chart 13Speculators Are Long The Euro For ##br##The First Time In Three Years Speculators Are Long The Euro For The First Time In Three Years Speculators Are Long The Euro For The First Time In Three Years Incredibly, two-year real interest rate differentials between the euro area and the U.S. have widened by 41 basis points in favor of the latter since the end of March, even though EUR/USD has actually rallied over this period (Chart 12). We think this divergence has occurred because investors have been busy covering the euro hedges that they put on in the lead up to the French elections. However, now that net long speculative positions in the euro have risen to a three-year high - having been deeply short just a few weeks ago - the speculative demand for euros will subside (Chart 13). With all this in mind, we are going short EUR/USD today with a year-end target of parity and a stop-loss of 1.14. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 The fiscal thrust is defined as the change in the structural primary budget balance from one year to the next. As a convention, we define a positive thrust as loosening in fiscal policy (i.e., a lower fiscal balance). 2 Please see Global Investment Strategy Weekly Report, "Does China Have A Debt Problem Or A Savings Problem?" dated February 24, 2017, and "China Needs More Debt," dated May 20, 2016, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights The equity risk premium (ERP) is distorted: too low. The Eurostoxx600 uptrend is reaching a technical limit according to its 130-day (6-month) fractal dimension. The U.S.-Euro area bond yield spread is distorted: too high. The Spain-France bond yield spread is distorted: too high. The Italy-Germany bond yield spread is not distorted. Feature Central banks' massive interventions in markets have left many investors wondering: has the market's price discovery mechanism become dysfunctional - and if so, where most severely? It is a good question because clearly, the prices that are most distorted are also the ones most likely to dislocate, and generate lucrative opportunities. This week's report assesses the distortion in three important relative pricings: the Italy-Germany sovereign yield spread; the U.S.-euro area sovereign yield spread; and the prospective excess return from equities over bonds, otherwise known as the equity risk premium. The Italy-Germany Bond Yield Spread Is Not Distorted We often hear the claim that the ECB's bond purchase program has compressed periphery bond yields relative to core yields. But we find no evidence for such a distortion. For example, relative to the ECB's capital key1 and other guidelines for bond purchase volumes, there is a larger ongoing supply of Italian BTPs than German bunds.2 So from a technical perspective, the ECB's interventions should have depressed German bund yields more than Italian BTP yields, thereby expanding the spread. Chart Of The WeekLow Volatility: We've Been Here Before... And It Didn't Last Low Volatility: We've Been Here Before...And It Didn't Last Low Volatility: We've Been Here Before...And It Didn't Last In fact, the technical distortion seems quite small because the Italy-Germany yield spread can be fully justified by its two underlying fundamentals: relative competitiveness (Chart I-2) and euro breakup probability (Chart I-3). Chart I-2Euro Area Yield Spreads Depend On Relative Competitiveness ... Euro Area Yield Spreads Depend On Relative Competitiveness... Euro Area Yield Spreads Depend On Relative Competitiveness... Chart I-3... And The Probability Of Euro Break-Up ...And The Probability of Euro Break-Up ...And The Probability of Euro Break-Up The premium on Italian BTP yields exists as a compensation for the expected redenomination loss in the tail-event of euro breakup. Assuming this currency depreciation would neutralize Italy's current 25% under-competitiveness versus Germany, we can infer that the 125 bps yield premium on 5-year BTPs is pricing a 5% annual probability of euro breakup (because 125 bps = 25% loss times 5% probability). The probability should account for an Italian election that is due within the next year, and Italian public support for the euro hovering at an unconvincing majority of around 55%. In this context, the probability should be somewhat elevated, though not alarming. So a 5% annual probability of euro breakup through the next five years seems reasonable within its post-crisis 2%-20% range. On this basis, the Italian-Germany yield spread is not distorted (Chart I-4). Instead, the real anomaly is the Spain-France (5-year) yield spread which stands at 50 bps (Chart I-5). There is now no difference in competitiveness between Spain and France, so there should be no redenomination premium on Spanish Bonos over French OATs, irrespective of the probability of euro break up. Stay structurally overweight Spanish Bonos versus French OATs. Chart I-4The Italy-Germany Yield Spread At 150 Bps Is Fair The Italy-Germany Yield Spread At 150bps Is Fair The Italy-Germany Yield Spread At 150bps Is Fair Chart I-5The Spain-France Yield Spread At 50 Bps Is Too High The Spain-France Yield Spread At 50bps Is Too High The Spain-France Yield Spread At 50bps Is Too High The U.S.-Euro Area Bond Yield Spread Is Distorted: Too High If bond price discovery were based solely on economic fundamentals, the U.S.-euro area yield spread would not be at a multi-decade extreme today. Such an extreme spread exists because the difference between Fed and ECB policy is much more polarized than is justified by the economic fundamentals. In this sense, the relative pricing is distorted. Consider the hard data. The percentages of the working age population in employment are at the same respective pre-crisis highs in both economies; the difference in wage inflation is closing; and the gap between core inflation in the U.S. and euro area has narrowed very sharply to just 0.6%. Indeed, excluding the cost of shelter - which is not represented in the euro area CPI - core inflation in the U.S. is now lower than in the euro area. Agreed, Fed policy should be tighter than ECB policy. But the expected difference should not be at a multi-decade extreme. Given the self-proclaimed 'data-dependency' of both the Fed and the ECB, the polarization of monetary policy expectations (Chart I-6) has to converge to the rapidly narrowing gap in the hard economic data, one way or another (Chart I-7). Chart I-6The U.S.-Euro Area Yield ##br##Spread Is Too High ... The U.S.-Euro Area Yield Spread Is Too High... The U.S.-Euro Area Yield Spread Is Too High... Chart I-7... And Will Gravitate To The Narrowing ##br##Gap In The Economic Data ...And Will Gravitate To The Narrowing Gap In Economic Data ...And Will Gravitate To The Narrowing Gap In Economic Data I conclude that: the U.S.-euro area (and U.S.-Germany) yield spread can close much further; euro/dollar can rise structurally; and the market neutral equity pair-trade long euro area Financials/short U.S. Financials can continue to outperform. The caveat is that these positions are just one big correlated trade (Chart I-8 and Chart I-9). Chart I-8Expected Monetary Policy Difference ##br##Is Driving The U.S.-Germany Yield Spread ... Expected Monetary Policy Difference Is Driving The U.S.-Germany Yield Spread... Expected Monetary Policy Difference Is Driving The U.S.-Germany Yield Spread... Chart I-9... And Therefore The Relative ##br##Performance Of Financials ...And Therefore The Relative Performance Of Financials ...And Therefore The Relative Performance Of Financials The Equity Risk Premium Is Distorted: Too Low Equity market behaviour is starkly asymmetric; market ascents tend to be gentle and drawn out, while descents tend to be violent and abrupt. By contrast, bond market behaviour is more symmetric; both upward and downward moves can be gentle or violent. The upshot is that when the equity market is ascending, its observed volatility declines. And the longer and more established the ascent becomes, the lower the observed volatility goes, both in absolute terms and relative to bonds. Crucially, this is just an observation of the inherent behaviour of equities: a low observed volatility simply tells us that equity ascents are gentle and drawn out (Chart I-10); it does not tell us that equity risk has diminished. Chart I-10Low Volatility Just Tells Us That Equity Ascents Are Gentle And Drawn Out. ##br##It Does Not Tell Us That Equity Risk Has Diminished! Low Volatility Just Tells Us That Equity Ascents Are Gentle And Drawn Out. It Does Not Tell Us That Equity Risk Has Diminished! Low Volatility Just Tells Us That Equity Ascents Are Gentle And Drawn Out. It Does Not Tell Us That Equity Risk Has Diminished! Unfortunately, the decline in the observed volatility may create the illusion that equity risk has diminished. In response, investors might demand a smaller (or no) equity risk premium (ERP) - the excess prospective long-term return over bonds - because they have falsely concluded that the risk of a large intermediate loss is vanishing. In turn, the shrinking ERP and lower required return justifies an even higher price today, allowing the market to continue its gentle ascent. So observed volatility falls even further, and the process feeds on itself in a self-reinforcing spiral. Readers might recognise this as the setup of the Minsky hypothesis in which the illusion of systemic stability breeds systemic instability and an eventual tipping point - a so-called 'Minsky Moment'. The Minsky hypothesis is an explanation for the boom bust cycle in the economy. It proposes that a credit boom initially generates strong and steady growth with low observed volatility. But the associated hubris - "no more boom and bust" - eventually encourages reckless lending and thereby sows the seeds of its destruction. When the misallocated loans cannot be repaid, the inevitable nemesis arrives. Likewise, in the case of the equity market, today's low observed volatility is absolutely not a reason for hubris. Yet as demonstrated in Markets Suspended In Disbelief,3 the low observed volatility has seduced investors into accepting a wafer-thin ERP. Today's low observed volatility is at the lower end of a range that has existed for at least 50 years (Chart of the Week). We have been here many times before. In each case, the low observed volatility did not last. And when it rose, so too did the ERP. As supporting evidence, observe that the 130-day (6-month) fractal dimension of the Eurostoxx600 is suggesting that the current uptrend is reaching its technical limit (Chart I-11). As a reminder, when an investment's fractal dimension approaches its natural lower bound, it signals that excessive trend following and groupthink have reached a natural point of instability. At which point the established trend is likely to break down with or without an external catalyst. Chart I-11The Current Uptrend In The Eurostoxx600 ##br##Is Reaching Its Technical Limit The Current Uptrend In The Eurostoxx600 Is Reaching Its Technical Limit The Current Uptrend In The Eurostoxx600 Is Reaching Its Technical Limit Before making a large absolute commitment to the equity asset class on a 6-12 month or longer horizon, I would first like to see both of these trustworthy signals stop flashing red. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 The capital key refers to the proportion of the ECB's capital owned by each of the euro area member states, and it is broadly pro-rata to the member state's GDP. 2 German GDP is 2 times the size of Italian GDP, but the stock of German sovereign debt is only 1.1 times the size of Italian sovereign debt. 3 Published on April 13 2017 and available at eis.bcaresearch.com Fractal Trading Model* The 65-day fractal dimension of nickel versus tin is approaching a level which has previously signaled an imminent trend-reversal. Go long nickel/short tin as this week's trade. Chart I-12 Long Nickel/Short Tin Long Nickel/Short Tin 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. 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 - 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

Highlights This week, we are reprising and updating "The Other Guys In The Oil Market" from our sister service Energy Sector Strategy (NRG), because it so well captures the state of oil production outside the U.S. shales, Middle East OPEC and Russia. "The Other Guys" account for ~ half of global supply. Next week, we'll publish a joint report with NRG analyzing today's OPEC meeting. The aptly named "Other Guys" account for ~ 42mm b/d of production, which they are struggling to maintain at current levels, let alone increase. These producers supply nearly half of global production, and have been stuck in a pattern of slow decline for years despite high oil prices. Beginning in 2019, we expect production declines to accelerate. This will put enormous pressure on the three primary growth regions, which markets likely will start pricing in toward the end of next year. Energy: Overweight. OPEC 2.0 is expected to extend its 1.8mm b/d of production cuts to the end of 1Q18 at its meeting in Vienna today. Going into the meeting, markets were being guided to expect even deeper cuts. Our long Dec/17 Brent $65/bbl calls vs. short $45/bbl puts, and our long Dec/17 vs. Dec/18 Brent positions are up 75.0% and 509.5% respectively, following their initiation on May 11, 2017. Base Metals: Neutral. Steel and iron-ore prices are getting a boost from China's anti-pollution campaign, which is expected to run through the end of this month. This was launched ahead of the anti-pollution campaign we expected after the Communist Party Congress in the fall. Iron ore delivered to Qingdao is up 3.1% since May 9, when Reuters reported the campaign began.1 Precious Metals: Neutral. Gold was well bid earlier in the week on the back of a weaker USD. Our long gold position is up 1.9%, while our long volatility trade, which we will unwind at tonight's close, is down 98.5%. Ags/Softs: Underweight. The weaker USD takes some pressure off wheat and beans over the short term, and might prompt a short-covering rally. We remain bearish, however, as the USD likely will bottom in the near future.2 Feature U.S. Onshore, Middle East OPEC (ME OPEC), and Russia combine to produce ~43 MMb/d of oil plus another ~11 MMb/d of other liquids (NGLs, biofuels, refinery gains, etc.). Combined, these producers increased crude production by 5 MMb/d plus another 1 MMb/d of other liquids production over the past three years (2014-2016), creating the oversupply that crashed prices. We expect these producers to add another 1.60 MMb/d of oil plus 1.14 MMb/d of other liquids by 2018 (over 2016 levels), dominated by nearly 2.0 MMb/d of oil and NGLs from the U.S. shales. Oil production from the other 100+ global oil producers also represents about ~42 MMb/d, but on balance has been slowly eroding since 2010, failing to grow even when oil prices were $100+/bbl. Despite some 2017 recovery from Libya, we expect total production to continue to fall in both 2017 and 2018. The few recently expanding producers among the Other Guys are running out of growth. Canada, Brazil, North Sea and GOM account for ~13 MMb/d of oil production in 2016, adding ~1.5 MMb/d over the past three years (2014-2016). North Sea production is projected to resume declines starting in 2017; GOM will reach it peak production sometime in 2017 or 2018, then start to ebb; large new Canadian oil sands projects will add ~310k b/d in 2017-2018, but scarce additions are scheduled beyond that; and Brazil's once-lofty growth plans have slowed to a crawl in 2016-2018. Global deepwater drilling activity and exploration spending have collapsed, lowering the reserve base, and undermining the stability of current production levels. Outside Of Just Three Regions, Oil Supply Picture Looks Worrisome Often overlooked in our discussions about world oil markets are the supply contributions of over 100 geographic regions. This collection of suppliers (which we will call the "Other Guys") is defined as all producing regions in the world other than: 1) U.S. Onshore (shales, specifically), 2) OPEC's six Middle East members, and 3) Russia. The Other Guys deliver nearly half of global production, try to maximize production every day (even OPEC nations among the Other Guys have not had production constrained by quotas), and still have endured consistent, albeit modest, production declines over the past six years. Chart 1Outside Of A Very Few Regions,##BR##Oil Production Has Struggled Outside Of A Very Few Regions, Oil Production Has Struggled Outside Of A Very Few Regions, Oil Production Has Struggled At the end of 1Q17, oilfield-services leader Schlumberger voiced sharp concerns regarding stability of supplies from these ignored producers, warning that aggregate capital expenditures within these regions will sustain an unprecedented third straight year of decline in 2017, with total spending only about half of 2014 levels. Chart 1 shows the divergent production histories of the three growing regions versus the rest of the world. Chart 1 also shows production of the Other Guys excluding the especially dramatic declines/volatility of Libyan production. Even though these producers benefitted from the same incentives and profitability from high oil prices as the three growing regions, as a group, they have been unable to expand production. As oil prices have plunged, drilling activity in these nations has also plummeted, raising concerns that production declines could start accelerating in the near future. Chart 2 shows that oil-directed drilling activity among the international components of the Other Guys (Chart 2 excludes GOM and highly-seasonal Alaska and Canada) has crashed by ~40%, from an average of over 800 rigs during the five-year period of 2010-2014 to under 500 rigs for the past year. Offshore drilling has collapsed even a little more sharply for these producers than overall oil-directed drilling, falling ~43% from an average of over 280 rigs to only 160 today (Chart 3, excludes GOM). Chart 2Other Guys' Drilling##BR##Has Collapsed 40% Other Guys' Drilling Has Collapsed 40% Other Guys' Drilling Has Collapsed 40% Chart 3International Offshore Drilling Is Down Over 40%,##BR##Boding Poorly For The Stability Of Future Production International Offshore Drilling Is Down Over 40%, Boding Poorly For The Stability Of Future Production International Offshore Drilling Is Down Over 40%, Boding Poorly For The Stability Of Future Production Offshore Production Declines To Accelerate Chart 4Other Guys' Offshore Drilling Has Collapsed Other Guys' Offshore Drilling Has Collapsed Other Guys' Offshore Drilling Has Collapsed As a particularly worrisome trend for the Other Guys' production stability, offshore drilling activity has collapsed in some of the most important offshore oil producing regions in the world, including the GOM, North Sea, West Africa, and Brazil (Chart 4). Considering the multi-year lag between drilling activity and the start of oil production, and the large well size and quick declines associated with offshore wells, the oil production impacts of this drilling collapse that started two years ago have not really been felt yet. When these regions get past the wave of new production from 2015-2017 project additions (projects started during 2011-2014), they will face a dearth of new projects maturing in 2018-2022 due to this collapse in drilling, with new production likely to be inadequate to offset the declines of legacy production. Brazil, the North Sea, West Africa, and GOM together account for about 12 MMb/d of oil production (Chart 5). These four offshore regions have benefitted from intense investment from 2010-2015 as shown by the surging rig counts during that period in Chart 4. This investment/drilling drove 1.1 MMb/d of oil production growth in Brazil, the GOM, and the North Sea from 2013 to 2016, without which total production from the Other Guys would have declined by 1.4 MMb/d rather than just 0.3 MMb/d. Despite strong investment, production in West Africa merely held flat outside of Nigeria during 2013-2016 while falling by 0.4 MMb/d within Nigeria (mostly in 2016 due to pipeline disruptions from saboteurs). Chart 5Offshore Production Will Stop Expanding, Then Decline The Other Guys In The Oil Market, Redux The Other Guys In The Oil Market, Redux Brazil offshore drilling activity over the past year is less than half of levels during 2010-2013. As a result, production growth will moderate significantly over the next few years, expanding far less (250k b/d in 2018 vs. 2016, based on our balances data) than the rapid 470,000 b/d step-up in production during 2013-2014. While Brazil still has a rich endowment of pre-salt reserves, marshalling capital and the International Oil Companies' (IOCs) focus to resurrect development activity will take years. We expect no growth during 2019-2020. The North Sea has seen production cut in half from the time of peak production in 1999 until 2013. Production declines were briefly halted and re-expanded by ~300,000 b/d during 2014-2016 due to a concerted drilling effort and brownfield maintenance program incentivized and financed by $100/bbl oil prices. Drilling has since declined 35% from average 2010-2014 levels, and production is expected to resume its downward trend in 2017-2018. Overall oil-directed offshore drilling in the GOM has been cut by over 50% from 2013-2014 levels. Based on our field-by-field analysis published in January, we estimate GOM oil production will hit a peak in a year and a half or less and then will succumb to declines due to lack of new drilling. West Africa has suffered production declines for the past several years due to both geologic challenges as well as more recent (2016-2017) political/sabotage related disruptions in Nigeria. With offshore drilling activity plummeting 70%-80%, we expect production declines will accelerate and it will take years of increased drilling to yield new production that can stem the declines. The collapse in Nigerian drilling, from 10 rigs in 2010-2013 to only 2-3 rigs over the past year, likely means that Nigerian production is incapable of returning to 2015 levels even if its recent sabotage issues are resolved. In aggregate, as shown in Chart 5, we expect production from these four offshore regions to stagnate during 2017-2018 (North Sea and West Africa decline while Brazil and GOM expand) before declining by ~0.5 MMb/d in each 2019-2020 due to the dramatic curtailment of investment during 2015-2017. SLB Talks Its Book, But Makes A Strong Point At an industry conference at the end of March, Schlumberger (again) railed against the inadequacy of the cash flow-negative U.S. shale industry to single-handedly supply enough production growth to satisfy continuing global demand growth, especially once the Other Guys start seeing more pronounced negative production effects from the sharply reduced investments over 2015-2017. "The 2017 E&P spend for this part of the global production base...is expected to be down 50% compared to 2014. At no other time in the past 50 years has our industry experienced cuts of this magnitude and this duration." - Paal Kibsgaard, CEO of SLB. SLB highlighted an analysis of depletion rates constructed with data from Energy Aspects. (The March 27 presentation can be found at www.slb.com). Annual depletion rates (annual production/proved developed reserves) in the GOM had spiked to over 20% in 2016 from a long-term level of only ~10% during 2000-2013. Similarly, depletion rates in the U.K. and Norwegian sectors of the North Sea also surged from ~10% to ~15% over the past three years. In both the GOM and the North Sea, oil production had recently been expanded, but proved developed reserves declined. Due to such low drilling investments during 2015-2016, producers have replaced only about half of the oil reserves that they've produced in the GOM and North Sea over the past three years (2014-2016). Eventually, this lack of investment in cultivating tomorrow's resources will catch up to the industry, and production will decline. Investors must take SLB's commentary with a grain of salt, as they could be construed as sour grapes. The immense pull of new capital spending to the U.S. shales has substantially benefitted SLB's primary competitors more than it has benefitted SLB (SLB is much more focused on international and offshore projects). Still, investors are too complacent about the stability of non-U.S. production. SLB's analysis and warnings of accelerating production declines should not be ignored. Bottom Line: Outside of the three regions of sharply growing production (U.S. onshore, ME OPEC and Russia) that investors are focused on, the other half of global production has been stagnant to declining despite high oil prices and high levels of drilling during 2010-2015. Now that drilling and capex in these regions has declined by 40%-50%, production declines should accelerate in coming years. Offshore production, especially, has not seen enough drilling to replace reserves, and is poised to decline within the next 2-3 years. The accelerating declines of the "Other Guys" will allow more room for growth from U.S. shales, ME OPEC and Russia. Matt Conlan, Senior Vice President, Energy Sector Strategy mattconlan@bcaresearchny.com 1 Please see "China steel hits nine-week peak amid crackdown, lifts iron ore," published by reuters.com May 22, 2017. 2 Please see the feature article in last week's edition of BCA Research's Foreign Exchange Strategy entitled "Bloody Potomac," in which our colleague Mathieu Savary lays out the case for an imminent USD rebound. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 Summary of Trades Closed in 2016 The Other Guys In The Oil Market, Redux The Other Guys In The Oil Market, Redux The Other Guys In The Oil Market, Redux The Other Guys In The Oil Market, Redux

Highlights U.S. Politics: We recommend that investors look through the political noise in D.C., which is unlikely to arrest the current cyclical economic upturn. Maintain a pro-growth asset allocation within fixed income portfolios: below-benchmark duration, favoring corporate credit over government bonds, especially in the U.S. Duration Checklists: An update of our Duration Checklists shows that the backdrop remains conducive to rising Euro Area bond yields, while the upward pressures on U.S. yields have diminished somewhat. The majority of the indicators, however, continue to point to higher U.S. Treasury and German Bund yields. Europe: Reduce European duration exposure, but wait for wider spread levels before moving out of European government bonds into U.S. Treasuries. Feature The Economy Trumps Politics Chart of the WeekHas Anything Really Changed? Has Anything Really Changed? Has Anything Really Changed? A whiff of panic swept across global financial markets last week, as the political risk bugaboo came back with a vengeance. In the U.S., the deepening morass surrounding President Trump's decision to fire former FBI Director Comey, and the potential links to the ongoing investigation of the White House's ties to Russia, raised concerns that Trump's ambitious pro-growth policy agenda would never make it out of Congress. Even this year's darling in the Emerging Markets, Brazil, suffered a huge financial rout after news broke of corruption allegations against the current president. Amid growing talk of a potential impeachment of Trump, the market action was a classic risk-off move, with equity markets falling, the VIX finally waking from its slumber and safe-haven assets like gold, U.S. Treasuries and the Japanese yen rallying. The euro climbed to new 2017 highs versus the U.S. dollar, without any changes in expectations about potential policy moves from the European Central Bank (ECB), as the market knocked down the probability of a June Fed rate hike (Chart of the Week). Some creative commentators called these market moves "the Trump fade" - the beginnings of a reversal of the so-called "Trump trade" that has sent U.S. equity prices and bond yields higher since the U.S. election on expectations of a large U.S. fiscal stimulus. We remain skeptical, however, that expectations of tax cuts and increased government spending have been the main drivers of the post-election boost in U.S. stock prices and Treasury yields, as the current cyclical upturn in global growth was already underway before Trump's election victory. Our colleagues at the BCA Geopolitical Strategy service note that, despite Trump's terrible overall approval ratings (Chart 2), his support among his Republican voters remains strong (Chart 3). Thus, an impeachment is only likely if the Republicans were to lose control of the House of Representatives in next year's U.S. midterm elections. Fear of that outcome should motivate the GOP to try and push through tax and healthcare reform well ahead of the 2018 midterms, in order to present a positive economic message to voters.1 Unless the evidence against Trump becomes so damning that even the Republicans in Congress have to focus on impeachment instead of policy, investors should ride out any market volatility associated with worries that the Trump economic agenda is at risk. Chart 2Trump's Support Abysmal Fade The "Trump Fade" Fade The "Trump Fade" Chart 3GOP Not Yet Willing To Impeach Trump Fade The "Trump Fade" Fade The "Trump Fade" Even without a boost to growth from D.C., however, we continue to expect the U.S. economy to grow above 2.5% in 2017. This above-trend pace will keep the Fed in play for at least two additional rate hikes before year-end, as it would give policymakers confidence that U.S. inflation expectations would return back the Fed's 2% target. In addition, as we discuss in the next section, the cyclical upturn in the Euro Area economy is showing no signs of cooling off, which will put more pressure on the ECB to begin preparing the markets for an eventual tapering of its asset purchases. The recent decline in bond yields is unlikely to persist much longer. Bottom Line: We recommend that investors look through the political noise in D.C., which is unlikely to arrest the current cyclical economic upturn. Maintain a pro-growth asset allocation within fixed income portfolios: below-benchmark duration, favoring corporate credit over government bonds, especially in the U.S. Checking In On Our Duration Checklists In a Special Report published back in February, we introduced a list of indicators to follow to assess the likely direction of U.S. Treasury and German Bund yields.2 We called these our "Duration Checklists", incorporating data on economic growth, inflation, investor risk aversion and market technicals to judge whether our bias to maintain a below-benchmark duration stance should be maintained. This week, we provide an update on those Checklists. The current message from the Checklists is that there is reduced upward pressure on bond yields from the overall strength of the global economy than existed four months ago. Domestic forces, however, are still pointing to higher yields in the U.S. and, especially, the Euro Area (Table 1). Specifically: Table 1A More Bond-Bearish Backdrop For Bunds Than USTs Fade The "Trump Fade" Fade The "Trump Fade" Global economic activity indicators have lost some momentum. While the global leading economic indicator (LEI) is still rising, our global LEI diffusion index has fallen sharply and is now below the 50 line, indicating that a more countries now have a falling LEI. In addition, the global ZEW index has drifted a touch lower, global data surprises are no longer positive, and the global credit impulse has ticked downward (Chart 4). Only the rising LEI warrants a "check" in our Checklists (i.e. justifies our current below-benchmark duration stance). U.S. & European domestic economic activity remains in good shape. Consumer and business confidence remains at strong levels on either side of the Atlantic, with corporate profit growth still accelerating (Charts 5 & 6). Only the modest decline in the U.S. manufacturing purchasing managers' index (PMI) is worthy of an "x" in our U.S. Checklist, although the index remains well above 50 and is not pointing to a more serious deterioration in the U.S. economy. Chart 4Global Growth Backdrop Has##BR##Turned Less Bond-Bearish Global Growth Backdrop Has Turned Less Bond-Bearish Global Growth Backdrop Has Turned Less Bond-Bearish Chart 5U.S. Economic Strength##BR##Still Supports Higher UST Yields U.S. Economic Strength Still Supports Higher UST Yields U.S. Economic Strength Still Supports Higher UST Yields Chart 6Euro Area Growth Is##BR##Gaining Upward Momentum Euro Area Growth Is Gaining Upward Momentum Euro Area Growth Is Gaining Upward Momentum Inflation pressures have eased a bit, especially in the U.S. The slowing momentum in global energy prices has taken some of the steam out of headline inflation in both the U.S. and Europe. Wage inflation has eased up a bit in the U.S., even with the labor market running at full employment (Chart 7). Wage growth and core inflation have recently ticked higher in the Euro Area, however, while the unemployment rate there has fallen to within less than a percentage point away from the OECD estimate of the NAIRU (Chart 8).3 The only indicators worthy of a "check" are the unemployment gap in both the U.S. and Euro Area, although we will give a potential "check" (with a question mark) to European wage inflation. If the recent uptick gains additional momentum, the case for the ECB to begin moving to a less accommodative policy stance will be much stronger. Chart 7Inflation Pressures On UST Yields Have Eased Inflation Pressures On UST Yields Have Eased Inflation Pressures On UST Yields Have Eased Chart 8Core Inflation & Wages Bottoming Out In Europe? Core Inflation & Wages Bottoming Out In Europe? Core Inflation & Wages Bottoming Out In Europe? There is still a pro-risk bias among global investors. U.S. and Euro Area equity markets are still in bullish trends, trading well above their 200-day moving averages. At the same time, corporate credit spreads remain tight and option-implied equity volatility is very low (even after last week's pop in the U.S. on the Trump drama). All indicators are worthy of a "check", suggesting that easier financial conditions can lead to higher bond yields (Charts 9 & 10). We are, however, giving an "x" to the European Checklist for the deviation of the Stoxx 600 from its moving average, as it is now at the +10% extreme that we defined as being potentially bond-bullish as it could foreshadow a near-term correction of an overheated stock market. Chart 9Still Generally A Risk-Seeking Backdrop In The U.S. Still Generally A Risk-Seeking Backdrop In The U.S. Still Generally A Risk-Seeking Backdrop In The U.S. Chart 10Strong Risk-Seeking Behavior In Europe Strong Risk-Seeking Behavior In Europe Strong Risk-Seeking Behavior In Europe Bond markets no longer look technically stretched. The sharp move higher in yields at the end of 2016 left all our indicators of yield momentum at bearish extremes (for bond prices). With bond yields pulling back from 2017 highs, however, the momentum measures all look neutral at the moment and are not an impediment to higher yields (Charts 11 & 12). The same goes for duration positioning in the U.S., with the net longs on 10-year Treasury futures now at the highest level since 2007. All of the technical indicators in our Checklists warrant an "check". Chart 11UST Technicals No##BR##Longer Stretched UST Technicals No Longer Stretched UST Technicals No Longer Stretched Chart 12Technicals Are No Impediment##BR##To Higher Yields In Europe Technicals Are No Impediment To Higher Yields In Europe Technicals Are No Impediment To Higher Yields In Europe Summing it all up, our Duration Checklists show that the majority of indicators are still pointing to higher bond yields in the U.S. and Europe, although not as decisively as when we first published the Checklists in February. There are more "check" on the European side of the ledger, however, suggesting that there is more room for European government bond yields to rise relative to U.S. Treasuries. This would indicate a potential trade opportunity to cut allocations to Europe and raise allocations to the U.S. Chart 13UST-Bund Spread Is Now Too Low UST-Bund Spread Is Now Too Low UST-Bund Spread Is Now Too Low The recent decline in U.S. yields, however, has narrowed the U.S. Treasury/German Bund spread to levels that make putting on a tightening trade unattractive on a tactical basis. (Chart 13). The gap between the data surprise indices in the U.S. and Euro Area already reflects the recent soft patch for the U.S. economy (middle panel). That spread in the surprise indices now at historically wide levels, suggesting more potential for Treasury yields to rise if the U.S. data begins to rebound soon, as we expect. Also, the gap between U.S. and Euro Area inflation expectations has narrowed alongside the recent downtick in U.S. core inflation (bottom panel), although we expect the decline in U.S. core inflation to be short-lived given the persistent tightness of the U.S. labor market. Net-net, we would prefer to see a wider Treasury-Bund spread before making switching our country exposure out of Europe and into the U.S. We can, however, listen to the message from our Checklists and reduce our duration exposure in Europe. Specifically, we are cutting our allocations to the longer maturity buckets (5 years out to 30 years) by 50% in our model portfolio for Germany, France and Italy, putting the proceeds into the 1-3 year buckets (see the table on Page 12). This will reduce our overall recommended portfolio duration by just over 1/10th of a year, as well as put an additional bear-steepening curve tilt within our European government allocations. We are comfortable with that bias, given the growing risk that the ECB will soon begin signaling a tapering of asset purchases once the current program expires at the end of the year. Bottom Line: An update of our Duration Checklists shows that the backdrop remains conducive to rising Euro Area bond yields, while the upward pressures on U.S. yields have diminished somewhat. The majority of the indicators, however, continue to point to higher U.S. Treasury and German Bund yields. Reduce European duration exposure, but wait for wider spread levels before moving out of European government bonds into U.S. Treasuries. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment", dated May 17 2017, available at gfis.bcaresearch.com 2 Please see BCA Global Fixed Income Strategy Special Report, "A Duration Checklist For U.S. Treasuries & German Bunds", dated February 15 2017, available at gfis.bcaresearch.com 3 Non-Accelerating Inflation Rate Of Unemployment. The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Fade The "Trump Fade" Fade The "Trump Fade" Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Dear Client, In addition to this Special Report, I am sending you our usual Weekly Report focusing on the market implications from the brewing crisis in the Trump White House. Best regards, Peter Berezin, Chief Global Strategist Highlights Chart 1Commodity Prices: A Halting Comeback Commodity Prices: A Halting Comeback Commodity Prices: A Halting Comeback Commodity prices have managed to stage a halting comeback over the past two weeks, but still remain well below their highs for the year. Concerns over the Chinese economy, a withdrawal of speculative demand, and strong supply growth have all weighed on commodity prices. All three of these forces should ebb over the coming months. This should provide a more benign cyclical backdrop for commodities and commodity-related investment plays. We went long the December 2017 Brent futures contract two weeks ago. The trade is up 7.8% since then. Stick with it. The cyclical recovery in commodity prices will benefit DM commodity currencies such as the CAD, AUD, and NOK. Go short EUR/CAD. Feature What's Been Weighing On Commodities? Commodity prices have managed to stage a halting comeback over the past two weeks, but still remain well below their highs for the year (Chart 1). We see three reasons why commodities have struggled to gain traction over the past few months: Fears that the Chinese economy is losing growth momentum have intensified. Traders have soured on the commodity complex, causing speculative demand to fizzle. Skepticism about OPEC's ability to maintain production discipline has been running high. All three of these forces should ebb over the coming months. This should provide a more benign cyclical backdrop for commodities and commodity-related investment plays. Global Growth: An Uneven Picture After a strong end to 2016, global growth so far this year has been mixed. The euro area has continued to hum along, with real GDP increasing by 2% in Q1 on an annualized basis. Japanese growth clocked in at 2.2% in Q1. This marked the fifth consecutive quarter of positive growth - the first time this has happened in 11 years! In contrast, U.K. growth slowed to 1.2% in Q1, while the U.S. registered a disappointing 0.7% growth print. As discussed in the Weekly Report that accompanies this Special Report, the U.S. economy is likely to bounce back over the remainder of the year, notwithstanding the ongoing soap opera that has become the Trump presidency. However, even if that happens, traders have become increasingly concerned that stronger U.S. growth will be offset by weaker growth in China. China Growth Risks Back In Focus All four Chinese purchasing manager indices fell in April (Chart 2). This week's data releases saw below-consensus growth in industrial production, retail sales, and fixed asset investment. Tighter financial conditions have contributed to the recent growth shortfall (Chart 3). The PBoC has drained excess liquidity over the past few months, causing overnight rates to rise. Corporate bond yields have surged while Chinese small cap stocks have taken it on the chin. The slowdown in Chinese growth is a cause for concern, but some perspective is in order. The economy began the year on a strong footing. Nominal GDP increased by 11.8% in Q1, compared with 9.6% in Q4 of 2016. Real GDP rose by 6.9% in the first quarter, comfortably above the government's target of 6.5%. A modest slowdown from these levels is not surprising. Most indicators point to an economy that is still expanding at a decent clip. Export growth is accelerating and our China team's model suggests that this will remain the case, thanks to solid global demand and a competitive RMB (Chart 4). America's latest anti-dumping measures on some Chinese steel products are irrelevant from a big picture point of view, as U.S. steel imports from China only account for a mere 1% of Chinese steel output. Chart 2China: PMIs Falling Across The Board China: PMIs Falling Across The Board China: PMIs Falling Across The Board Chart 3Financial Conditions Have Tightened In China Financial Conditions Have Tightened In China Financial Conditions Have Tightened In China Chart 4China: The Rebound In Exports Should Continue China: The Rebound In Exports Should Continue China: The Rebound In Exports Should Continue Meanwhile, fixed investment is benefiting from an upturn in the profit cycle. Chart 5 shows that excavator sales, railway freight traffic, and the PBoC's Entrepreneur Confidence Index - all leading indicators for Chinese capex - are surging. Even the housing market is well positioned to withstand some policy tightening. Land purchases by developers have rebounded and the most recent central bank survey showed that households' home-buying intentions jumped to an all-time high in the first quarter (Chart 6). Chart 5Positive Signs For Chinese Capex... Positive Signs For Chinese Capex... Positive Signs For Chinese Capex... Chart 6...And The Housing Market ...And The Housing Market ...And The Housing Market Efforts Focused On Containing Financial Risk Most of the government's tightening measures have been designed to reduce financial sector risks while inflicting as little collateral damage on the economy as possible. So far, this strategy appears to be working: While broad credit growth has slowed from a high of 25.7% in January 2016 to 15.5% in April of 2017, almost all of that was due to a deceleration in borrowing by non-bank financial institutions. The pace of lending to nonfinancial private borrowers and the government - the so-called "real economy" - has barely fallen from last year. In fact, medium- and long-term loans to the corporate sector, a key driver of overall capital spending, have accelerated (Chart 7). The inversion of the Chinese yield curve largely reflects these macroprudential measures. The spread between 10-year and 5-year government bond yields turned negative last week, the first time this has ever happened (Chart 8). Chart 7China: Credit Growth To The Real EconomyBarely Affected By Tightening Measures China: Credit Growth To The Real Economy Barely Affected By Tightening Measures China: Credit Growth To The Real Economy Barely Affected By Tightening Measures Chart 8Chinese Yield Curve Inversion Chinese Yield Curve Inversion Chinese Yield Curve Inversion Some pundits have interpreted this development as an omen of a coming recession. However, there is a less dramatic explanation: Up until recently, non-bank financial institutions have been issuing so-called wealth management products like crazy. According to Moody's, the outstanding value of these products soared from U.S. $72 billion in 2007 to $4.2 trillion in the first quarter of 2017. The crackdown on shadow banking has forced many participants to liquidate their positions which, in many cases, included substantial leveraged holdings of government bonds. Since 5-year bonds are less liquid than their 10-year counterparts, yields on the former have increased more than on the latter. The Commodity Connection While the data is sketchy, it appears that Chinese non-bank financial institutions have been major players in the commodities market. As funding to these institutions - and their clients - dried up, panic selling of commodity futures contracts ensued. This withdrawal of Chinese investment demand for commodity markets began at time when, globally, long speculative positions were highly elevated. Chart 9 shows that net long spec positions as a share of open interest for energy and industrial commodities reached the highest levels in over a decade earlier this year. Today, speculative positioning has returned to more normal levels. This reduces the risk of a further downdraft in commodity prices. At the same time, the Chinese authorities appear to be relaxing some of their earlier tightening measures. The PBoC re-started its Medium-Term Lending Facility (MLF) earlier this week. It also made the largest one-day cash injection into the financial system in nearly four months on Tuesday. This follows the release of stronger-than-expected credit numbers for April, as well as Premier Li Keqiang's call over the weekend for "striking a balance" between enhancing financial stability and maintaining growth. Adding to the newfound easing bias, general government fiscal spending is now recovering (Chart 10). Chart 9Commodities: Long Speculative Positions Returning To More Normal Levels Commodities: Long Speculative Positions Returning To More Normal Levels Commodities: Long Speculative Positions Returning To More Normal Levels Chart 10China: Fiscal Spending Is On The Mend China: Fiscal Spending Is On The Mend China: Fiscal Spending Is On The Mend Oil Supply Should Tighten Chart 11Oil Inventories Should Decline Oil Inventories Should Decline Oil Inventories Should Decline Tighter supply conditions in various parts of the commodity complex should reinforce the upward pressure on prices stemming from firming demand. This is especially true for crude oil. Saudi Arabia and Russia announced earlier this week that they will support an extension of output cuts through to March 2018. Despite a sharp recovery in shale output, BCA's energy strategists expect global production to increase by only 0.5 MMB/d in 2017 compared to 1.5 MMB/d growth in consumption. Consequently, oil inventories should fall over the remainder of this year. Inventory draws will continue through 2018, albeit at a slower pace than in 2017 (Chart 11). Larger-than-expected declines in U.S. oil inventories over the past two weeks, along with a steep reduction in the volume of oil held in tanker ships (so-called "floating storage"), suggest that this trend has already begun. Some Investment Implications Fading fears about a China slowdown and a tighter supply picture will lift commodity prices over the remainder of the year. We went long the December 2017 Brent futures contract two weeks ago. The trade is up 7.8% since then. We are targeting a further 10% in upside from current levels. The cyclical recovery in commodity prices will benefit the stocks and bonds of companies within the resource sector. It will also benefit DM commodity currencies such as the CAD, AUD, and NOK. In addition, rising commodity prices will provide a tailwind to emerging markets, although Fed rate hikes and the occasional political scandal (here's looking at you, Brazil!) will take some bloom off the rose. The prospect of higher commodity prices supports our recommendation to be overweight euro area stocks relative to U.S. equities. The IMF estimates that the European economy is three-times more sensitive to changes in EM growth than the U.S. (Chart 12).1 If higher commodity prices give emerging markets a boost, this will help Europe's large industrial exporting companies. Calculations by JP Morgan suggest that petrostate sovereign wealth funds hold five times more European equities than U.S. stocks, even though European stocks account for less than half the global market capitalization of U.S. stocks.2 These funds are especially exposed to European financials and consumer discretionary names. Higher oil prices would give them greater scope to add to their favorite positions. What about EUR/USD? The run-up in the euro over the past few weeks was partly driven by the unwinding of sizable short hedges that traders put on in the lead up to the French elections. At this point, euro positioning has moved from being highly bearish to broadly neutral. Going forward, fundamentals will play the dominant role. On the one hand, an outperforming euro area equity market should attract foreign capital into the region, giving the common currency a boost. On the other hand, interest rate differentials will continue to move in favor of the dollar. As we discussed last week, the Fed is likely to raise rates by more than the 38 basis points that markets are currently pricing in over the next 12 months.3 In contrast, the ECB is likely to stand pat, given that the rate of labor underutilization is still 18% in the euro area, 3.5 percentage points higher than in 2008 (Chart 13). If anything, rising inflation expectations in the euro area could cause real short-term rates to decline, putting downward pressure on the euro. Chart 12Europe Is More Sensitive To EM The Signal From Commodities The Signal From Commodities Chart 13Labor Market Slack In The Euro Area Remains High The Signal From Commodities The Signal From Commodities Our research indicates that real interest rate differentials are by far the most important drivers of currency returns over cyclical horizons of around 12 months. The decline in the dollar over the past few weeks has occurred alongside an increase in real rate differentials between the U.S. and its trading partners. Notably, two-year real rate differentials have widened by 47 basis points versus the euro area since the end of March, even though the dollar has actually weakened against the euro over this timeframe (Chart 14). Thus, a period of "catch-up strength" for the dollar is in order. We continue to expect EUR/USD to reach parity by the end of the year. With all this in mind, we are opening a new trade today: Short EUR/CAD (Chart 15). Chart 14Widening Real Rate Differentials Support The Dollar Widening Real Rate Differentials Support The Dollar Widening Real Rate Differentials Support The Dollar Chart 15Play The Cyclical Recovery In Oil Via The EUR/CAD Play The Cyclical Recovery In Oil Via The EUR/CAD Play The Cyclical Recovery In Oil Via The EUR/CAD Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see "IMF Multilateral Policy issue Report: 2014 Spillover Report," IMF, dated July 29, 2014. 2 Nikolaos Panigirtzoglou, Nandini Srivastava, Jigar Vakharia, and Mika Inkinen, "Flows & Liquidity," J.P.Morgan Global Asset Allocation (January 29, 2016). 3 Please see Global Investment Strategy Weekly Report, "The Fed's Dilemma," dated May 12, 2017, available at gis.bcaresearch.com.

Highlights The political theater in Washington has caused the last inning of the dollar correction to materialize. The U.S. economy remains at full employment, growth will stay above trend, and the Fed will be capable of hiking rates by more than the 66 basis points priced into the OIS curve over the next 24 months. It is time to buy the DXY. Investors are too optimistic on the euro and too negative on the CAD, short EUR/CAD as a tactical bet. The Swedish economy continues to improve. Yet, the SEK has limited upside as the Riksbank continues to find excuses to justify its dovishness. The downside for EUR/SEK is limited to 9.3. Feature Chart I-1Trump Rally Is Gone Trump Rally Is Gone Trump Rally Is Gone Four weeks ago, we wrote that the U.S. dollar correction was entering its last inning and recommended investors should wait a few more weeks before betting on renewed dollar strength.1 We think the time to bet on this rebound is now. To begin with, the dollar index has now erased all the gains accumulated since Trump's electoral victory, suggesting that all the hope of fiscal stimulus, deregulation, and tax cuts have now been priced out of the greenback (Chart I-1). In fact, at this point in time we think too many risks have been priced into the dollar. For one, the market is overemphasizing the likelihood of a Trump impeachment. While our Geopolitical Strategy group does think the likelihood of an impeachment procedure is near 100% if the democrats win the House in 2018, the likelihood remains much lower in 2017.2 Simply put, Trump remains a very popular president among republican voters (Chart I-2). Most problematic for many republicans that would like to see Trump out of office, is that his popularity is particularly strong among the "Tea Party" districts and voters (Chart I-3). Chart I-2Trump Still Popular With Republicans Bloody Potomac Bloody Potomac Chart I-3Trump Is Popular In Tea Party Territory Bloody Potomac Bloody Potomac Second, the chance that tax cuts are part of the upcoming budget negations is high. Tax cuts are espoused by the entire GOP caucus. Additionally, Republicans know that in order to avoid losing the Senate or the House of Representatives, or both, they have to do something popular with voters. Tax cuts definitely fit the bill. This simple political assessment points toward a likely passage of stimulus in the coming quarters despite Trump's personal woes. Finally, if Trump were to be stabbed in the back by the GOP establishment, what would the impact be on the dollar? Would the U.S. default? No. Would the economy enter a recession? No. Would the Fed become dovish? Neither. If anything, a potential removal of Trump from the oval office reduces the risk that he appoints a super-dove at the helm of the Fed, a risk that would have been very negative for our positive dollar cyclical stance. Regarding the economics behind the dollar rally, our positive cyclical stance on the USD predates the election of Trump, and in fact relied on the underlying shifts in the U.S. economy.3 These dynamics are still intact: While wage growth remains anemic, this partly reflects the fact that the long-term determinant of wage growth, productivity growth, is low. When this is taken into account, productivity-adjusted wage growth is in line with levels that in the past have prompted the Fed to tighten policy in order to combat potential inflationary dynamics (Chart I-4). Nonetheless, the risk is that wages begin accelerating going forward. The labor market is at full employment, with the U-3 unemployment rate standing 0.3 percentage points below the Fed's estimate of the neutral unemployment rate. Additionally, hidden labor market slack has also greatly dissipated (Chart I-5), with the U-6 unemployment rate, the number of workers in part-time jobs for economic reasons, and the amount of workers outside of the labor force but that would still like to have a job if economic conditions warranted it all back to levels where historically wage growth has gained momentum. Chart I-4Without Productivity Gains, Current Wage##br## Growth Is Enough For A Tighter Fed Without Productivity Gains, Current Wage Growth Is Enough For A Tighter Fed Without Productivity Gains, Current Wage Growth Is Enough For A Tighter Fed Chart I-5U.S. Labor Market##br## Is Tight The Labor Market Is Tight U.S. Labor Market Is Tight The Labor Market Is Tight U.S. Labor Market Is Tight Moreover, the outlook for consumption remains sturdy. Overall household income growth remains supported by elevated levels of job creation, and our indicator for real household disposable income growth continues to point up. Additionally, Federal income tax withholdings are accelerating, a sign of more robust consumption to come (Chart I-6). With consumer confidence at 17-year highs, positive income developments are likely to be translated into consumption. The outlook for capex is also bright. CEO confidence and capex intentions have all rebounded sharply, moves whose genesis predate Trump's election (Chart I-7). Moreover, elements are in place for these positive feelings to be catalyzed into actual investment. On the back of rebounding revenue growth, thanks to nominal GDP growth exiting levels historically associated with recessions, profit growth will receive a fillip, which should boost capex in the current context (Chart I-8). Chart I-6Income Tax Receipts Points ##br##To Healthy Consumption Income Tax Receipts Points To Healthy Consumption Income Tax Receipts Points To Healthy Consumption Chart I-7Capex Intentions Point ##br##To Higher Growth Capex Intentions Point To Higher Growth Capex Intentions Point To Higher Growth Chart I-8Revenue Growth Exiting ##br##Recessionary Levels Revenue Growth Exiting Recessionary Levels Revenue Growth Exiting Recessionary Levels Finally, when all major indicators are aggregated, real GDP growth looks set to accelerate. BCA's Beige Book diffusion index, based on the distribution of positive and negative mentions about the state of the economy in the Fed's Beige Book, is pointing to an acceleration in activity (Chart I-9). This suggests that the collapse in U.S. economic surprises may be toward its tail end. With this in mind, we continue to expect the Fed to increase rates more than the 66 basis points currently anticipated in the OIS curve over the next two years, as such, this supports our bullish stance on the dollar. In terms of tactical developments, the recent selloff has brought the DXY toward the levels congruent with the end of the correction.4 Additionally, based on our Intermediate-term timing model, the USD is now cheap enough to justify taking a long bet on the currency. The deeply oversold levels reached by our Intermediate-term momentum oscillator supports this message (Chart I-10). Finally, the Swedish Krona seems to be confirming these signposts. USD/SEK has historically displayed one of the strongest betas to the trade-weighted dollar's movements. The fact that this pair has not been able to break down below a long-term upward slopping trend line put in place since 2014, and that it also managed to stay above its 2015 peaks, gives us more confidence that the dollar correction is likely to have run its course (Chart I-11). Chart I-9BCA's Beige Book Monitor ##br##Improves Growth Will Strengthen BCA's Beige Book Monitor Improves Growth Will Strengthen BCA's Beige Book Monitor Improves Growth Will Strengthen Chart I-10Dollar Is ##br##Oversold Dollar Is Oversold Dollar Is Oversold Chart I-11USD/SEK Giving A Hopeful##br## Signal For DXY USD/SEK Giving A Hopeful Signal For DXY USD/SEK Giving A Hopeful Signal For DXY Bottom Line: The dollar has taken a beating in the wake of the scandals emerging out of the White House. In our view, these developments were only the catalyst that crystalized the last leg of the USD correction that begun in late 2016/early 2017. Ultimately, the bull case for the dollar predates Trump and rests on the dissipating slack in the U.S. economy. These developments are intact, even with Trump's fiascos in the foreground. Tactically, the dollar is now cheap enough and oversold enough to justify investors buy the DXY again. We are opening a long DXY trade this week. We remain long the dollar against most commodity currencies and EM currencies. The yen may continue to benefit if the budding weaknesses in the EM space gather further momentum. EUR/CAD Is A Short At this juncture, it would be natural for us to begin shorting the EUR against the USD. In fact, we believe the recent spike in the EUR has created a good shorting opportunity against the European currency. While we worry investors are becoming too pessimistic on the U.S., we believe investors are too optimistic regarding the capacity of the ECB to increase rates. Investors moved away from deep short positions on the euro and are now net long this currency. Also, while in July 2016 investors expected the first ECB rate hike to materialize in more than five years' time, they are now expecting the first repo rate hike to happen in just 24 months (Chart I-12). This looks premature. For comparison's sake, in the U.S. we are only seeing the early signs of labor market tightness, despite the last recession ending in the summer of 2009. Europe was victim to a double-dip recession, the last leg of which ended in 2013. This decreases the likelihood of Europe being at full employment today. More concretely, there remains plenty of hidden labor market slack in the euro area. In Europe, the main form of slack exists among workers hired under contracts, contracts that do not offer the same level of benefits and protections as regular employment. The euro area increasingly has a dual labor market, a condition that has weighed on wage growth for more than two decades in Japan. Today, as a result of such dynamics, the level of labor underutilization in Europe is still very elevated, which will continue to limit wage growth going forward (Chart I-13). Hence, core inflation dynamics in Europe are likely to prove disappointing and they will keep the ECB on a more dovish path than investors currently appreciate. Chart I-12Investors Too Optimistic On The ECB Investors Too Optimistic On The ECB Investors Too Optimistic On The ECB Chart I-13Labor Market Slack In The Euro Area Remains High Bloody Potomac Bloody Potomac For now we are electing to profit from this view by tactically shorting the euro against the CAD. We do believe there are problems in Canada, a topic we discussed a few weeks ago.5 But at this juncture, these worries seem well digested by markets. The Home Capital Group debacle has been front page news for weeks, but the aggregate banking sector remains strong, especially as loses on the mortgage holdings of Canadian banks will ultimately be passed on to the government through the insurance provided by the Canadian Mortgage and Housing Corporation. Additionally, in the wake of the deepening trade dispute on softwood lumber, the fears of a disintegration of NAFTA have hit Canada especially violently, with the CAD falling 16% against the peso since January 2017. Chart I-14EUR/CAD Is Toppy EUR/CAD Is Toppy EUR/CAD Is Toppy Tactically, the pieces are falling into place to favor the CAD over the EUR. Our Commodity and Energy group remains positive on the outlook for oil prices. The continuation of the output controls by OPEC and Russia remains binding as oil producers want to further curtail elevated oil inventories. Therefore, oil prices have little downside and may even experience further upside, helping the CAD in the process. Additionally, investor positioning is very skewed. Investors are massively short the CAD, especially when compared to the euro, which historically has provided a signal to short EUR/CAD (Chart I-14). This is re-enforced by our Intermediate-term technical indicator which shows EUR/CAD as massively overbought. Shorter-term momentum measures such as the RSI or the MACD have also been forming negative divergences with actual prices in recent days. Bottom Line: The euro is likely to suffer if the USD correction is indeed finishing. Hidden labor market slack remains a much deeper problem in Europe than in the U.S. and will limit the capacity of the ECB to increase rates in the next two years, as investors are currently expecting. For now, we are electing to short the euro against the CAD instead of against the USD. The Canadian dollar is oversold and oil prices have limited downside from here as supply adjustments remain positive. Moreover, investors are at record shorts on the CAD, especially when compared to the euro. Sweden Is Strong, But The Riksbank Still Haunts The SEK The long-term outlook for both Sweden and the Swedish krona remain bright but the ultra-dovish stance of the Riksbank remains a potent short-term hurdle. To begin with, the SEK offers great value. Not only is it trading at 24% and 8% discounts to its PPP fair value against the USD and the EUR, respectively, but the trade-weight SEK is also trading at a near one-sigma discount against our long-term fair value models (Chart I-15). Chart I-15SEK Is Cheap... But Is It Enough? SEK Is Cheap... But Is It Enough? SEK Is Cheap... But Is It Enough? Additionally, Sweden's net international investment position has moved back in positive territory in 2014, and now stands 16.4% of GDP (Chart I-16). This is not only a reflection of the weakness in the SEK since 2014, but is first and foremost the end-result of more than two decades of accumulated current account surpluses. This development is crucial. Not only does the positive income balance generated by assets in excess of international liabilities put a floor under the current account; historically, currencies with positive and growing net international investment positions tend to exhibit an upward bias. In terms of economic developments, employment growth in Sweden remains steady. Unemployment has been in a protracted downtrend, falling 2.9 percentage points since 2008 (Chart I-17). Yet, despite being well into full employment territory, wage growth has been absent. To a large degree, this reflects entrenched deflationary pressures in the Swedish economy. However, deflationary forces are abating. Chart I-16A Long-Term Driver Pointing North A Long-Term Driver Pointing North A Long-Term Driver Pointing North Chart I-17Swedish Labor Market At Full Employment Swedish Labor Market At Full Employment Swedish Labor Market At Full Employment To begin with, Sweden's output gap has recently entered positive territory, which historically has been a reliable indicator of inflationary pressures in this country (Chart I-18). Also, monetary aggregates, M1 in particular, continue to point toward higher inflation in Sweden. This means that with the employment market being at full capacity, the conditions for higher inflation in Sweden are emerging. Our expectation of an upcoming upturn in the Swedish credit impulse - which until now has been contracting and exerting deflationary forces on the economy - reinforces confidence in our inflation view. Credit growth tends to lag industrial activity, but our industrial production model for Sweden is perking up. Improving industrial variables suggest that credit will move from depressing demand back to supporting demand, further rekindling inflationary forces (Chart I-19). Chart I-18Swedish Inflation Is Set To Pick Up Swedish Inflation Is Set To Pick Up Swedish Inflation Is Set To Pick Up Chart I-19Swedish Credit Impulse Will Rebound Swedish Credit Impulse Will Rebound Swedish Credit Impulse Will Rebound With this positive backdrop for prices, should investors buy the SEK right now? The Riksbank continues to represent a great hurdle for SEK bulls. The Swedish central bank has one of the strongest dovish biases amongst global monetary guardians. Against expectations, it recently increased the duration of its asset purchase program, giving markets a strong signal that it is unlikely to increase rates soon. This means that the Riksbank is unlikely to tighten policy until it sees the "whites of inflation's eyes". While we are moving in the right direction, we are not there yet. Officially, the Riksbank targets CPIF, which currently clocks in at 2%. Yet, the emphasis of the central bank on domestic price dynamics implies that adjustment away from dovishness will only occur when core inflation itself moves to 2% (Chart I-20). This means that gains in the SEK will be limited. To begin with, EUR/SEK does have downside, and our view that the euro is getting overextended highlights that EUR/SEK could fall toward 9.3. However, beyond this level, gains should prove limited as Sweden is a small open economy and EUR/SEK plays a big role in tightening monetary conditions for that country. As a result, any move in EUR/SEK below 9.3 is likely to be unwelcomed by the Riksbank until core inflation moves closer to 2%. Versus the USD, it will be even more difficult for the SEK to rally. Historically, the SEK has been one of the most sensitive currencies to the dollar's trend, implying that strength in DXY could be magnified in USD/SEK. In fact, the absence of breakdown in USD/SEK in the face of violent dollar selling pressures this week suggests that the SEK could be a serious casualty of a rebounding dollar. Additionally, real rate differentials continue to move in favor of the U.S. dollar, with U.S. 2-year real rates now 180 basis points above that of Sweden (Chart I-21). With the Intermediate-term technical indicator for USD/SEK now hitting oversold levels, the downside for USD/SEK is very limited, further supporting the idea that any rebound in DXY could lead to significant weaknesses in SEK. Chart I-20Core Inflation Needs To Rise Core Inflation Needs To Rise Core Inflation Needs To Rise Chart I-21Rates Differentials Support A Lower SEK Rates Differentials Support A Lower SEK Rates Differentials Support A Lower SEK Bottom Line: The Swedish economy has adjusted and several factors are pointing toward a pickup in core inflation in the coming quarters. However, the Riksbank has maintained a strong dovish bias. We need to see an actual pick up in core inflation itself before the central bank moves away from its dovish bias. While EUR/SEK could weaken toward 9.3, more gains for the krona against the euro will prove elusive until the Riksbank sees firmer inflation. USD/SEK is a buy at current levels. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Haaris Aziz, Research Assistant HaarisA@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report titled “The Last Innings Of The Dollar Correction”, dated April 21, 2017, available at fes.bcaresearch.com 2 Please see Geopolitical Strategy Special Report titled “Break Glass In Case Of Impeachment”, dated May 17, 2017, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report titled “Dollar: The Great Redistributor”, dated October 7, 2016, available at fes.bcaresearch.com 4 Please see Foreign Exchange Strategy Weekly Report titled “The Last Innings Of The Dollar Correction”, dated April 21, 2017, available at fes.bcaresearch.com 5 Please see Foreign Exchange Strategy Weekly Report titled “AUD and CAD: Risky Business”, dated March 10, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 The past week has been quite eventful for the greenback, slipping almost 2.3%. Most of the downside is owed to markets revising down rate expectations, on the basis of weak growth numbers and political scandals. The 10-year yield dropped, gold rose, and equities fell. There was also a large sell-off in EM currencies and a sharp appreciation in the yen. Furthermore, the soft patch in U.S. data continued as housing starts and building permits came in especially weak in April: 1.172 million and 1.229 million respectively, both underperforming consensus. Nevertheless, markets calmed after the release of stronger employment numbers with initial and continuing jobless claims beating expectations. The upswing in the Philly Fed index also helped revive sentiment. The dollar picked up Thursday morning following these releases. Interestingly, the DXY is at pre-election levels, which suggests that the dollar is nearing its bottom. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 The euro has enjoyed significant upside as a result of Macron's victory and the dollar's drubbing. Weak data in the U.S. caused markets to revise growth expectations, pressuring the dollar downwards and the euro up. Further lifting the euro were comments by ECB President Mario Draghi, who highlighted that growth in the euro area is performing well. However, he also reiterated that "it is too early to declare success". These forces have lifted the euro to expensive levels on a tactical basis, suggesting the path of least resistance is most likely down as the ECB will find it hard to tighten policy and the dollar resumes its bull market. Data in the euro area has been mixed as of late without too much disappointment, and inflationary pressured remain unchanged. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 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 After coming slightly above 114, USD/JPY has plunged by more than 3%, as a result of the market pricing increasing odds that president Trump will get impeached. Although we believe that the correction of the dollar has run its course, the end of the Trump trade might have triggered the sell-off we have been expecting in emerging markets. Thus we like to play this risk off period by shorting NZD/JPY. On the data side, news have mostly been negative: Machinery orders contracted by 0.7% YoY, underperforming expectations. Consumer confidence came in lower than last month at 43.2. Bank lending grew by a measly 3% YoY underperforming expectations. However, real GDP for Q1 came in at 0.5% QoQ, beating expectations. This was dampened by the weak GDP deflator, which contracted by tk%. We continue to be yen bears on a cyclical basis, as the fed will raise rates more than the markets expects, while the BoJ will continue anchoring 10-year yields around zero. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 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: Industrial Production growth came in at 1.4%, underperforming expectations. However retail sales and retail sales ex-fuel growth came in at 4% and 4.5% respectively, both outpacing expectations. Crucially, both core and headline inflation came above expectations at 2.4% and 2.7% respectively. This surge in inflation is important as it raises the odds of a BoE hike this year, especially as the economy remains resilient. Moreover, as long term inflation expectations continue to be well anchored consumption is likely to continue to surprise as households are looking through the inflation caused by the depreciation in the pound. Overall, we continue to be positive on GBP against all other currencies but the U.S. dollar, given that the British economy will likely stay more resilient than investors are anticipating. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 Updating Our Long-Term FX Value Models - February 17, 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 RBA shed some light on the Australian economy through its most recent Minutes, highlighting that monetary policy needs to remain accommodative to support economic trends. It noted the negative hit to terms of trade as a result of Cyclone Debbie curtailing coking coal exports. China's housing market was also identified as a risk to Australia's exports and terms of trade. Nevertheless, this week the AUD was buoyant, helped by a weaker greenback. However, the factors above paint a bleak picture for the AUD's future. The very important employment figures depicted a similar trend to that of last year, with full-time employment in fact contracting while part-time employment picked up. Unemployment also declined by 0.2% to 5.7%, however, wages remain subdued. This corroborates the weaker core CPI measure of 1.5%, while the strong headline figure of 2.1% is likely to be transitory when the recent commodity-prices weakness kicks in. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 AUD And CAD: Risky Business - March 10, 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 RBNZ continues to much more accommodative than warranted. The monetary policy report highlighted that the recent surge in inflation is mainly attributable to tradables, and that non-tradable inflation is bound to increase very gradually. We continue to believe that the RBNZ is understating the inflationary pressures in the economy, as core inflation is already higher than 2%. Additionally, retail sales are growing at 10-year high and nominal GDP growth has skyrocketed to 7.5%, by far the highest in the G10. Right now, the market expects the first rate hike to come in 9 months. We believe that a rate hike at this point would be the bare minimum for the RBNZ to avoid an overheating in the economy. Thus expectations have nowhere to go than up and the NZD now has considerable upside against the AUD. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 USD/CAD has been somewhat weaker this past week as oil prices rebounded and the dollar fell. Oil prices are likely to see further upside as OPEC and Russia are likely to agree to another supply cut to support oil prices. Domestically, the economy is improving as unemployment is declining and PMIs are perking up. The BoC also identified the output gap to close earlier than expected in its last meeting. The almost 4% depreciation in the CAD in the past month has made the oil-based currency considerably cheap. When looking at EUR/CAD, the depreciation has been around 7.5%. With the euro now sitting in expensive territory, the ECB is unlikely to change its stance any time soon as inflation has not yet rooted itself, while peripheral economies' inflation remain weak. The CAD, however, is likely to see further upside on the back of increasing oil prices and a strengthening economy. These factors warrant a short EUR/CAD trade. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 And CAD: Risky Business -AUD March 10, 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 Following the election of Emmanuel Macron as the new president of France EUR/CHF skyrocketed, coming close to hitting 1.1. At this point EUR/CHF is a very attractive short, given that good news for the euro are likely to tapper now that the French election is behind us. When it comes to inflation, the ECB will likely focus on the lowest denominator, because in spite of higher inflation in some countries like Germany or Austria, inflationary pressures remain muted in most other economies. This will prevent the ECB from tightening monetary policy as fast as the market expects. Meanwhile, the possibilities that the SNB takes the floor off EUR/CHF at the end of this year or the beginning of 2018 are rising given that inflation and economic activity are slowly coming back to Switzerland. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 Updating Our Long-Term FX Value Models - February 17, 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 USD/NOK has depreciated in the past weeks thanks to the fall in the dollar as well as rising oil prices. Additionally, the fall in inflation is slowing down, with core and headline inflation coming in at 1.7% and 2.2% respectively. Is it time to become bullish on the NOK against the U.S. dollar? We do not believe this is the case. While inflation might be close to bottoming it is unlikely to surpass the Norges Bank target in the coming years, given that inflationary pressures remain muted in Norway. Furthermore, given that USD/NOK is more sensitive to real rate differentials than oil prices, the effect of a dovish Norges Bank on USD/NOK will be much stronger than the impact of rising oil prices. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 We expect the SEK to experience limited upside in the next 3-6 months. The Greenback is bottoming and we expect USD/SEK to pick up on the back of the dollar bull market. Furthermore, EUR/SEK has limited downside as the RIksbank wants to keep monetary conditions easy. Indeed, the Swedish central bank is also planning to officially target CPIF instead of the CPI. While both of these measures are near 2%, the behavior of the Riksbank suggests that it is in fact targeting core inflation. Core inflation itself is still somewhat depressed, as consumer activity remains weak. However, we expect core inflation to pick up on the back of a higher credit impulse and money supply growth, which should help the Riksbank exit its dovish tilt later this year. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Four separate indicators provide compelling evidence for a 'mini-cycle' in activity. 1. The bond yield. 2. The credit impulse. 3. The steel equity sector price. 4. The consumer price index (CPI). Right now, the mini-cycle is about 4 months into downswing whose average duration tends to be about 8 months. Hence, the surprise in the coming months could be that inflation comes in below expectations. Feature Central to our European investment philosophy is the existence of what we call a 'mini-cycle' in global activity. Right now, this cycle is about 4 months into a mini-downswing whose average duration tends to be about 8 months. Within this global mini-cycle the irony is that Europe itself has been a paragon of stability. Quarter on quarter growth has remained within a remarkably narrow 1.2-2.2%1 band for eight consecutive quarters. And the dispersion of growth across euro area countries now stands at a historical minimum. We expect the euro area's relative stability to persist given the recent bottoming of the euro area 6-month bank credit impulse. Nevertheless, for the European investment and inflation outlook, the global growth cycle is as important, or more important, than the domestic cycle. In highly integrated and correlated international markets, the absolute direction of European asset prices takes its cue from a global rather than a local conductor. The pace of consumer price inflation also tends to be a global rather than a local phenomenon. For example, through the past 10 years, the inflation cycles in the euro area, U.K. and U.S. have been near identical (Chart I-2). Chart Of the WeekThe Steel Sector Has A Clear Mini-Cycle The Steel Sector Has A Clear Mini-Cycle The Steel Sector Has A Clear Mini-Cycle Chart I-2The Inflation Cycle Is Global, Not Local The Inflation Cycle Is Global, Not Local The Inflation Cycle Is Global, Not Local In this light, the ECB now correctly assesses that "the risks surrounding the euro area outlook relate predominantly to global factors." As we go on to show below, the surprise in the coming months could be that inflation comes in below expectations. This would slow the ECB's exit from its current ultra-accommodative monetary policy. But because these downside inflation surprises were coming from outside the euro area, it would force other central banks to become even more dovish relative to current expectations. On this basis, we are very comfortable to maintain our relative return positions in European investments: expect euro currency outperformance; T-bond/German bund yield spread convergence; and euro area Financials outperformance versus global Financials. For absolute return positions, expect the relatively benign backdrop for bonds to continue into the summer months. Mini-Cycles: The Evidence Mounts In previous reports, we presented two pieces of evidence for economic mini-cycles. First, the global bond yield shows a remarkably regular wave like pattern with each half-cycle averaging about 8 months (Chart I-3). Second, the acceleration and deceleration of bank credit flows - as measured in the credit impulse - also exhibits a remarkably regular wave like pattern, with each half-cycle also lasting about 8 months (Chart I-4). Chart I-3The Bond Yield Has A Clear Mini-Cycle The Bond Yield Has A Clear Mini-Cycle The Bond Yield Has A Clear Mini-Cycle Chart I-4The Credit Impulse Has A Clear Mini-Cycle The Credit Impulse Has A Clear Mini-Cycle The Credit Impulse Has A Clear Mini-Cycle We proposed that the bond yield and credit impulse cycles are inextricably embraced in a perpetual feedback loop: a higher bond yield weighs on credit flows; this slows economic growth which then shows up in activity data; in response, the bond market lowers the bond yield; the lower bond yield boosts credit flows, which lift economic growth; and so on... But as each stage in the sequence comes with a delay, the bond yield and credit impulse mini-cycles should be 'out of phase'. And this is precisely what the empirical evidence shows (Chart I-5). Chart I-5The Bond Yield And Credit Impulse Mini-Cycles Are Out Of Phase The Bond Yield And Credit Impulse Mini-Cycles Are Out Of Phase The Bond Yield And Credit Impulse Mini-Cycles Are Out Of Phase Now, to build an even stronger case for mini-cycles we will add a third and fourth piece of compelling evidence. The third piece of evidence is the steel equity sector price, which is an excellent real-time indicator of the growth cycle, and shows exactly the same mini-cycle profile as the bond yield (Chart of the Week). The fourth piece of evidence is the consumer price index (CPI) which also presents an identical mini-cycle profile (Chart I-6). Chart I-6The Consumer Price Index Has A Clear Mini-Cycle The Consumer Price Index Has A Clear Mini-Cycle The Consumer Price Index Has A Clear Mini-Cycle As with the bond yield and the steel equity sector price, we have de-trended the CPI to better show the underlying cyclicality. But in the case of the CPI, our chosen de-trending rate of 2% has special significance: 2% is the inflation target for most central banks. Hence, if the de-trended CPI is rising, inflation is running above the 2% target; if the de-trended CPI is falling, inflation is running below the 2% target. In this regard, the mini-cycle in the CPI carries a disturbing asymmetry. Observe that in recent mini-upswings, inflation has just about reached the 2% target. But in each and every mini-downswing, inflation has substantially undershot the 2% target. Based on the regularity of the mini-cycle through the past 10 years, we can estimate that we are about half way into a mini-downswing. If so, the surprise in the coming months could be that inflation comes in below expectations, frustrating the ECB. Still, as the disinflationary surprises will emanate from outside the euro area, other major central banks might be even more frustrated. And this supports our aforementioned relative positions in European investments. What Is Your Most Provocative Non-Consensus View? The observation that inflation has struggled to reach 2% in mini-upswings, but substantially undershot 2% in each and every mini-downswing is very telling. The strong suggestion is that the recent modest uplift in inflation towards 2% could just be a mini-cyclical rather than structural phenomenon. The death of debt super-cycles combined with an incipient wave of Artificial Intelligence (AI) led automation still constitutes a very powerful structural deflationary force, which should not be underestimated. The technical pattern of bond yields also supports this thesis. Chartists will point out that the global bond yield is still in a well-defined pattern of lower highs and lower lows - which is to say a well-established downward channel (Chart I-7). And that it would take the yield to rise by a quarter (about 40 bps) to breach this channel. The German 30-year bund yield gives a very similar message (Chart I-8). Chart I-7Still In A Structural Downtrend: The Global Bond Yield... Still In A Structural Downtrend: The Global Bond Yield... Still In A Structural Downtrend: The Global Bond Yield... Chart I-8...And The German 30-Year Bund Yield ...And The German 30-Year Bund Yield ...And The German 30-Year Bund Yield At meetings, clients often ask for the most non-consensus investment view - something to which the street attributes a 10% chance, but to which I attribute a 50% or higher chance. Given the asymmetrical mini-cycle behaviour of both inflation and bond yields and the powerful structural forces of deflation shown in the preceding charts, here is my provocative answer: Perhaps the structural low in bond yields is not behind us; perhaps it is to come in the next major global downturn. But this is a personal view. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 At an annualized rate. Fractal Trading Model* There are no new trades this week, leaving us with four 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. Fractal Trading Model Short CAC40 / Long EUROSTOXX600 Short CAC40 / Long EUROSTOXX600 * 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 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. 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Highlights Duration: The opposing forces currently pulling on global bonds - softer growth and core inflation readings vs. tightening labor markets - are keeping yields locked into narrow trading ranges. We expect the strength of the global upturn to reassert itself, leading to higher government bond yields and corporate credit outperformance over the balance of 2017. U.K./Canada/Australia: Economic data, as well as our bond market indicators, are giving conflicting signals for the outlook for yields in the U.K., Canada & Australia. Our analysis of the relative growth and inflation dynamics in the three countries leads us to recommend a 2-year/30-year yield curve box trade, positioning for a relatively flatter curve in Canada and a relatively steeper curve in the U.K. Portugal Trade Update: Improving growth indicators, and declining measures of banking sector risk, in Portugal have resulted in a sharp narrowing of government spreads versus Germany. We are exiting our short 10-year Portugal/long 10-year Germany Tactical Overlay trade this week, at a loss of -1.6%. Feature Chart of the WeekMarket Volatility Is Low For A Good Reason Market Volatility Is Low For A Good Reason Market Volatility Is Low For A Good Reason What was once a fairly straightforward narrative for global bond markets earlier this year is now being challenged. Growth data has cooled a bit in the U.S. and China, while commodity prices have fallen, suggesting that the global economy may be losing steam even with leading indicators still rising and the European economy looking robust. At the same time, core inflation measures have ticked lower despite the signs of tighter labor markets throughout the developed world. These moves on the margin have stalled the upturn in global bond yields, resulting in lower fixed income market volatility that is likely playing a role in keeping realized equity market volatility at depressed levels (Chart of the Week). We continue to see the recent pullback in U.S. data as being temporary in nature. The economy should improve in the coming months given the still-solid trends in U.S. corporate profits and household income and the still-low level of interest rates. The signs of a building China slowdown are potentially more worrisome, especially on the inflation front given how much Chinese demand has boosted commodities and overall traded goods prices over the past year. Although we are not expecting a major Chinese downturn that could spill over more broadly to the world economy, it is likely that the next leg up in inflation in the developed economies will come from diminished spare capacity and rising core inflation, rather than a commodity-driven reacceleration of headline inflation. We continue to recommend a strategic underweight overall portfolio duration stance, as we expect the Fed to deliver on its planned rate hikes before year-end and the European Central Bank (ECB) to soon begin signaling a tapering of its asset purchases next year. We continue to favor corporate credit over sovereign debt, particularly in the U.S., given the strength of the current global upturn, but staying up in credit quality (i.e. focusing on Investment Grade and higher-rated credit tiers in High-Yield). Stuck On Neutral: Considering Trades Between Canada, Australia & The U.K. Over the past few months, we have upgraded our stance on government bond exposure in the U.K., Canada and Australia - all to neutral and all for essentially the same reason. There was not a compelling enough case to expect any of the central banks in those countries to move interest rates before year-end, in either direction, given the lack of sustainable inflation pressures and mixed messages on growth. With policymakers stuck on hold for the foreseeable future, keeping our recommended bond weightings at benchmark was the logical (albeit unexciting) choice. Even the mixed messages sent by our own bond indicators highlight the difficulty in making a decisive market call at the moment. Our Central Bank Monitors for Canada and Australia have recently flipped into the "tighter policy required" zone, joining the U.K. Monitor which has been there for some time (Chart 2).1 This would suggest moving to an underweight stance in anticipation of tighter monetary policy in those countries that is currently not priced into money market curves (bottom panel). Yet the best performing bond market of the three over the past two years has been the U.K. - a trend that started before last year's Brexit vote when the U.K. economy was in relatively good shape and the Bank of England (BoE) was starting to send hawkish messages. Gilts now look the most overvalued judging by the current negative real yields on offer (Chart 3), yet our U.K. Central Bank Monitor is showing signs of topping out, further adding to the confusion. Chart 2Markets Don't Expect Anything From BoE/BoC/RBA Markets Don't Expect Anything From BoE/BoC/RBA Markets Don't Expect Anything From BoE/BoC/RBA Chart 3Gilts Look Most Expensive Gilts Look Most Expensive Gilts Look Most Expensive Having mixed directional signals, however, does not imply that there are not trade opportunities within these markets. Even if the BoE, the Bank of Canada (BoC) and the Reserve Bank of Australia (RBA) are not in a hurry to begin hiking interest rates, domestic growth and inflation pressures are building at a different pace within these economies, creating potential cross-market trade opportunities. Economic Growth: Canada has the strongest leading economic indicator, manufacturing PMI and consumer sentiment, but the softest business confidence (Chart 4) - perhaps because of concerns over the future protectionist trade policies of U.S. President Donald Trump. In the U.K., a combination of falling real wage growth and persistently high levels of political uncertainty after Brexit are weighing on consumer sentiment, yet business confidence is the strongest of the three countries. Meanwhile, overall confidence in Australia is the weakest, even with manufacturing in a strong upturn. Most worryingly, real consumer spending is slowing rapidly in all three countries, although it is holding up relatively better in Canada. Inflation: The differences in price pressures are less pronounced (Chart 5). Inflation rates are similar among the three economies as Australian core CPI inflation appears to have finally bottomed out in the first quarter of this year after falling steadily since 2014. All three countries are witnessing decelerating wage growth, however, even with solid job growth in Canada over the past year. Spare capacity measures like the output gap and unemployment gap show the U.K. economy being closest to full employment (Chart 6). Spare capacity is steadily being absorbed in Canada, although the BoC attributes this to a slower pace of potential GDP growth, according to last month's BoC Monetary Policy Report (MPR).2 Chart 4Canadian Economic Data Looks Strongest bca.gfis_wr_2017_05_16_c4 bca.gfis_wr_2017_05_16_c4 Chart 5No Major Inflation Differences No Major Inflation Differences No Major Inflation Differences Home Prices & Debt: The housing markets remain an issue in Canada and Australia, where home prices look severely overvalued with household debt at elevated levels (Chart 7). The governments in both countries are trying to use regulatory and macro-prudential solutions to cool red-hot housing demand, but rapid growth in housing wealth remains a source of stimulus for consumers at the moment. The situation is different in the U.K., where home valuations and debt levels are nowhere near as elevated as in the other two countries (although London homeowners may disagree). Chart 6No Spare Capacity In The U.K. No Spare Capacity In The U.K. No Spare Capacity In The U.K. Chart 7Household Debt A Concern In Canada & Australia Household Debt A Concern In Canada & Australia Household Debt A Concern In Canada & Australia Exports: Each country is also exposed to a different major economy via the export channel. The OECD leading economic indicators for the U.S., Euro Area and China (the largest export markets for Canada, the U.K. and Australia, respectively) are all ticking higher, suggesting that export demand should pick up for Canada, the U.K. and Australia in the near term (Chart 8). However, Australian exports to China have already expanded at a 60% annual rate and our Emerging Market and China strategists are expecting some cooling of Chinese growth in the latter half of this year; slower export growth should be expected. Chart 8An Unsustainable Surge In Aussie##BR##Export Demand From China An Unsustainable Surge In Aussie Export Demand From China An Unsustainable Surge In Aussie Export Demand From China After adding up all the pieces, it is still difficult to select one government bond market over the others in absolute terms. The U.K. would appear to have the least bond-friendly backdrop, with higher inflation and very low real interest rates. Yet the BoE is worried about many factors - Brexit uncertainties on trade and business confidence, declining real household income growth - that should prevent them from shifting to a less accommodative monetary stance before year-end that would involve reduced Gilt purchases and/or outright interest rate hikes. Conversely, Australia seems to have the most bond-bullish climate - a still-negative output gap, plunging consumer confidence, very low inflation and the heaviest exposure to a Chinese economy that is set to cool off. Yet while core inflation remains low at 1.5%, it appears to be bottoming out and the RBA is currently forecasting that its preferred measure of underlying inflation will move up to 2% - the low end of its 2-3% target range - by early 2018, according to their just-released Statement on Monetary Policy.3 In Canada, the BoC continues to take a very cautious view on Canadian growth, despite the robust 4% real GDP growth seen in the first quarter of this year. Sluggish growth in exports and capital spending is expected to be a drag on growth this year, according to the April BoC MPR. Yet the central bank is now "decidedly neutral" and is no longer considering a rate cut as it was earlier this year according to BoC Governor (and BCA alumnus) Stephen Poloz.4 Given all the various factors pushing and pulling on these three economies and central banks, it is perhaps no surprise that yield moves have been highly correlated across these bond markets over the past several months (Chart 9). The most attractive near-term risk/reward opportunities now appear to be in relative yield curve trades rather than directional allocations or cross-country spread trades. Specifically, we see an opportunity to play for a steeper Gilt curve, and a relatively flatter Canadian government bond curve, via a 2-year/30-year box trade. Given the strong readings on current and leading economic indicators in Canada, combined with our view that the recent patch of slower U.S. growth will prove to be temporary, we see the greatest potential for upside growth surprises in Canada. The BoC is likely to wait before delivering rate hikes until there is decisive evidence of accelerating inflation, especially given the potential economic risks deriving from the Canadian housing bubble. However, better-than-expected growth will exert more flattening pressure on the Canadian yield curve than the U.K. or Australian curves, where downside growth risks are greater. Already, the very front end of the Canadian curve is starting to disengage from the U.K. and Australian curves, with the 2-year/5-year flattening modestly in Canada and the other markets showing steepening curves at similar maturities (Chart 10, top panel). We expect that relative flattening pressure to exert itself further out the yield curve for Canadian government debt over the latter half of 2017. Chart 9Yields Are Highly Correlated... Yields Are Highly Correlated... Yields Are Highly Correlated... Chart 10...Curve Slopes, Slightly Less Correlated ...Curve Slopes, Slightly Less Correlated ...Curve Slopes, Slightly Less Correlated In the U.K., the long end of the Gilt curve has rallied to very rich levels, with the 10-year/30-year slope now trading near the bottom of the range that has prevailed since 2014 (bottom panel). Much of that has been driven by a decline in longer-term inflation expectations that has accompanied the more stable British Pound. While the uncertainty surrounding the upcoming Brexit negotiations with the European Union will likely weigh on business confidence and investment spending in the U.K., the immediate impact of the robust Euro Area economy on U.K. exports should provide a boost to U.K. economic growth. Coming at a time when the U.K. is at, or even beyond, full employment, this should put some mild upward pressure on inflation expectations further out the curve, leading to steepening pressures on a relative basis to Canada. This can already be seen in looking at the 2-year/30-year yield curve box between the Canada and the U.K. in Chart 11. In all three panels, we show the steepness of the Canadian bond curve minus that of the Gilt curve, alongside the differentials in actual inflation, and market-based inflation expectations from the index-linked markets, between Canada and the U.K. As can be seen in the top two panels, the Canadian curve looks too steep relative to the U.K. curve given the higher rates of headline and core inflation in the U.K. The bottom panel shows that the 2-year/30-year box is in line with the relative inflation expectations within the two countries. We see this as a sign that U.K. inflation expectations are too low relative to actual U.K. inflation, leaving the Gilt curve too flat relative to the Canadian curve. While this would appear to argue for a relative trade between inflation-linked bonds in Canada and the U.K., the poor liquidity of the small Canadian linker market makes this a difficult trade for most investors to put on. We prefer to express the view via yield curves, particularly with the 2-year/30-year Canada-U.K. box currently priced in the bond forwards to move sideways over the rest of the year (Chart 12). This means that betting on a steeper Gilt curve relative to Canada does not incur negative carry - important for a trade with a more medium-term horizon like this. Chart 11Gilt 2/30 Curve Too Flat Relative To Canada Gilt 2/30 Curve Too Flat Relative To Canada Gilt 2/30 Curve Too Flat Relative To Canada Chart 12Enter A 2/30 Canada-U.K. Box Trade Enter A 2/30 Canada-U.K. Box Trade Enter A 2/30 Canada-U.K. Box Trade This week, we are adding this 2-year/30-year Canada-U.K. position to our strategic model portfolio at -7bps. The initial target is for the box to return to -50bps - the bottom of the range that has prevailed since 2015. A deeper decline would occur if the BoC begins to signal a rate hike in Canada at some point that puts even more flattening pressure on the Canadian curve, although that is not our base case expectation over the rest of 2017. The risk to the trade would come from a deceleration of U.K. inflation that eliminates the current divergence between realized and expected inflation. What about Australia? We anticipate that there will be an opportunity to move to an eventual overweight position in Australian bonds in the coming months to position for the slowing of Chinese growth, and the related demand for Australian exports, that we expect. We are choosing to stay neutral for now, however, given the current uptick in Australian inflation that muddies the water on any call on RBA monetary policy. Bottom Line: Economic data, as well as our bond market indicators, are giving conflicting signals for the outlook for yields in the U.K., Canada & Australia. Our analysis of the relative growth and inflation dynamics in the three countries leads us to recommend a 2-year/30-year yield curve box trade, positioning for a flatter curve in Canada and a steeper curve in the U.K. Tactical Overlay Housekeeping: Cutting Losses On Portugal Shorts One of our long-held positions in our Tactical Overlay trade portfolio has been a short position in Portugal 10-year government bonds versus a long position in 10-year German Bunds. We put the trade on last summer as part of a broader allocation at the time out of Peripheral European sovereign debt into core European debt. The logic was straightforward - the combined stress of decelerating economic growth and struggling banking systems in the Periphery (made worse by the ECB's negative interest rate policies) would result in some spread widening in Italy, Spain and Portugal. While that story remains true in Italy, both leading economic indicators and measures of financial sector risk like credit default swap (CDS) spreads for senior banks have a decline in Spain and Portugal. While we have already upgraded our recommended allocation to Spanish debt in our model portfolio, we had been reluctant to consider a similar move in Portugal given our concerns about its economy and, more importantly, its banking system. But with leading economic indicators starting to perk up and bank CDS spreads in Portugal falling sharply, and with German Bund yields rising alongside growing market nervousness of a potential ECB taper, Portugal-Germany spreads have tightened sharply. We are belatedly cutting our losses on this position this week and closing out the position at a loss of -1.6%. We plan on publishing a deeper dive on Portugal in the coming weeks to update our views on the country and its bond markets. Bottom Line: Improving growth indicators, and declining measures of banking sector risk, in Portugal have resulted in a sharp narrowing of government spreads versus Germany. We are exiting our short 10-year Portugal/long 10-year Germany Tactical Overlay trade this week, at a loss of -1.6%. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Special Report, "BCA Central Bank Monitor Chartbook", dated March 28 2017, available at gfis.bcaresearch.com. 2 http://www.bankofcanada.ca/wp-content/uploads/2017/04/mpr-2017-04-12.pdf 3 http://www.rba.gov.au/publications/smp/2017/may/pdf/statement-on-monetary-policy-2017-05.pdf 4 https://www.bloomberg.com/news/articles/2017-04-12/poloz-sees-faster-canada-return-to-full-capacity-key-takeaways The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Adventures In Fence-Sitting Adventures In Fence-Sitting Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns